Markets are waking up to the notion that inflation hasn’t peaked

It only took a 0.1% rise in consumer price inflation last month to send markets into their worst downward spiral in two years.

But what appears to be a relatively small increase — coupled with the fact that the total year-over-year number actually fell — belies a much larger shift in the markets.

As Nomura’s Charlie McElligott noted in a note published Wednesday morning, markets are now bracing for the possibility of a “hard landing” for the US economy as investors realize that inflation will be much more persistent than they anticipated.

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Others pointed out that investors are being stripped of their belief in “peak inflation” – the idea that price pressures have already peaked as energy prices have fallen from their highest levels earlier this year – and are now forced to face the fact that other factors, such as rising rental costs, will be much more persistent, meaning the Fed will have to keep rates high for longer.

“I think some investors were lulled into thinking that inflation could fall quickly because of the rapid decline in energy prices that played a part in that thinking,” said Mohannad Aama, portfolio manager at Beam Capital.

“The Fed is targeting unemployment and the shelter component of CPI,” he added.

To see: US inflation rages back in August, CPI shows, despite falling gas prices

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Ahead of Tuesday’s consumer price index report, economists had expected the decline in energy prices to keep headline inflation essentially stable.

Instead, a surprisingly large rise in rents and owners’ equivalent rents caused “core” inflation – an inflation measure that excludes volatile food and energy prices – to rise 0.6% in August, double the rate. the previous month’s increase, and also double the 0.3% expected by a survey of economists published by the Wall Street Journal.

To see:US will gain 315,000 jobs in August. Labor market still strong but showing signs of cooling

Derivatives traders already estimate that inflation will be more difficult to fight. According to CME’s FedWatch tool, they now see a nearly 30% chance that the Fed’s rate target will rise as much as 4.5% in July, and a 15% chance that it could even reach 4.75%. .

In addition, traders now estimate a near 30% chance that the Fed will have to raise a full percentage point next week, something the investment bank Nomura, McElligott’s employer, is already expecting.

See: The biggest Fed rate hike in 40 years? It could come next week

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As McElligott explains, higher interest rates are bad news for stocks as they are likely to hurt corporate consumption and capital spending, ultimately manifesting in slower economic growth and lower corporate profits.

According to CPI data released Tuesday, the cost of both owner’s rent and equivalent rent — which the Fed uses to reflect the cost of owning a home — rose 0.7% in August.

Fed Chair Jerome Powell has made it very clear that the Fed wants to see the rising cost of housing ease before the Fed moves back into easing monetary policy.

Others, of course, fear that the Fed is at risk of becoming too aggressive.

Kristina Hooper, the chief global strategist at Invesco, said in an email that she is concerned that “75 is the new 25,” meaning the Fed could risk causing unnecessary economic damage by continuing to implementing massive interest rate hikes.

“The impact of interest rate hikes takes time to show in economic data. And so I fear that any central bank that raises interest rates in 75 basis point increments will turn monetary policy into an even more blunt instrument, and risk overdoing it,” Hooper said in emailed comments.

Aama agreed that the economy may see an even bigger downturn before the full impact of the Fed’s rate hikes is felt. But that doesn’t mean the central bank should hold back, he said.

“Just as the Fed was late in walking and letting inflation out of the pocket, more aggressive rate hikes could end up doing too much damage before the full impact of past hikes is felt,” he said.

The unfortunate reality is that “peak inflation” is one of those things that can only be ascertained in retrospect, Aama said.

So far, US stocks have struggled to shake off the effects of Tuesday’s carnage. The S&P 500 SPX,
is slightly lower on the day in afternoon trading, while the Nasdaq Composite COMP,
and Dow Jones Industrial Average DJIA,
have risen 0.2%.

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