Higher CPI May Keep the Fed in Play

Financial markets received some unwelcome news on inflation on May 17: A government report showed that the overall U.S. consumer price index (CPI) jumped 0.6% in April, above economists' median forecast of a 0.5% rise, while the core index, which excludes food and energy prices, rose 0.3% (median 0.2%).

The upside surprise on the CPI core figure negated any benefit to the markets of the previous day's news of a lower-than-expected rise of 0.1% in the core producer price index for April.


  Investors quickly made their displeasure known as the inflation news dealt a blow to expectations the Federal Reserve will pause its series of interest-rate hikes at its June policy meeting. In midday trading on May 17, each of the major U.S. stock indexes had dropped more than 1%, while the yield on the benchmark 10-year Treasury note jumped from 5.12% to 5.18%.

The dollar moved marginally higher in the immediate aftermath of the report, though follow-through was surprisingly limited. The relative lack of reaction could be a good signal of how bearish overall sentiment on the dollar remains. Implied Fed funds rates rose on the CPI data to suggest that futures-market players see about 44% risk for a June rate hike.

On a year-over-year basis, the overall CPI accelerated to a 3.5% pace, from 3.4% in March, while the core rate rose to 2.3%, from 2.1%. The year-over-year April core rate is at the higher end of the Fed's comfort zone and just fractionally off the 2.4% cycle high.


  As expected, energy prices were a major culprit in the overall price advance, climbing 3.9%. Gasoline prices soared 8.8%. However, price pressures appeared to be rather widespread in April. The core rate was boosted by a 0.3% gain in shelter costs, a 0.6% increase in apparel, and a 0.4% gain in medical care. However, food prices were flat, which helped hold back the headline figure.

The CPI data raise the risk that a key barometer of inflation for the Federal Reserve, the PCE chain price index, will post a 0.2% gain rather than the 0.1% increase that we assume.

Both the April CPI and PPI headline figures were largely in line with expectations. It will be the tone of the next round of monthly inflation reports for the core figures that will spin market perceptions as we draw nearer to the next Fed policy meeting, in late June.


  As it stands, the year-over-year core pace of 2.3% in April will remain intact in May if we see a 0.2% gain on the month, as is the case for the 1.5% core PPI figure. The next round of monthly reports will certainly have tamer headline figures, as the recent spike in gasoline prices was fully captured in the April reports.

We still think that the Fed would prefer to pause in its tightening trajectory at 5% at the June FOMC meeting. Policymakers will need to weigh rising-price pressures against some mixed signals for the growth outlook, including a slowing housing market. In addition, the recent correction in stock and commodity markets may also factor into the Fed call. Overall, the June FOMC meeting is setting up to be the most contentious one of the current tightening cycle.

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