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U.S. inflation showed more signs of cooling in June, bolstering market expectations of a potential rate cut by the Fed. Sam Chai, Vice President for Active Fixed Income Portfolio Management at TD Asset Management, breaks down the latest CPI reading and the implications for monetary policy.
Transcript
Greg Bonnell – US inflation showing more signs of cooling in June, but will it be enough to convince the US Federal Reserve that the conditions are getting right for a rate cut in the coming months? Joining us now to discuss is Sam Chai, VP for Active Fixed Income Portfolio Management at TD Asset Management. Sam, great to have you back on the program.
Sam Chai – Pleasure to be here.
Greg Bonnell – Let’s talk about that number we got this morning. Clearly, it appears to be moving in the direction we’ve been waiting for it to move in.
Sam Chai – That’s true. That’s very true. So I wanted to give a breakdown of the CPI numbers we have. So obviously, very encouraging reports we have seen here. Both the headline and the core CPI inflation trend has moved meaningfully lower versus prior month, printing at negative 0.06% and 0.06%, respectively. The composition of the report is also very favorable. When we look at the core inflation metric, that is something the Fed focused on a bit more because it really shows the underlying inflation trend in the economy, and that has driven the bulk of the slowdown in inflation.
When we look at also the supercore component, which is something also the Fed’s favorite, that is really the core services component, ex the shelter component. That printed the second negative print in a row now. And when we compare that to the very sticky and high numbers in the first quarter, this really shows that the stickiness of inflation is coming down.
Thirdly, when we look at the owner equivalent rent component, which is the largest component in the core services component, that had a meaningful step down versus prior month, also very meaningful because that accounts for over 25% of the entire CPI basket. So, in order for inflation to come down sustainably towards the 2% target, we really need to see that component come down, and this is very favorable. And the current month-over-month rate is now roughly back to the pre-COVID years’ run rate, so that’s very encouraging.
And finally, for the core goods component, that has printed the 11th negative print over 12 months now, so continuing to be disinflationary, so also good. And just take a step back, when we look at the broader CPI trend as well, and just to put it into context, the core CPI this month, at 0.06%, is the lowest since early 2021. So really tells you how much progress we’ve made on the core inflation front.
But also, when you look at the three-month annualized Q2 inflation, that is now at 2.1%. When you compare that to Q1, that’s a meaningful slowdown. And this is basically, roughly, already at Fed’s target. And I do want to point out one caveat, though, which is that the pass-through from the CPI to PCE may not be as favorable this month–
Greg Bonnell – Of course, PCE is really what the Fed’s taking a look at, right?
Sam Chai – Exactly, exactly. That’s the preferred inflation metric. But, because of component differences, that may actually be a bit stronger this month, although will likely still be encouraging. And finally, just on the market reaction as well, just given those prints are a meaningful downside surprise to the market expectations, we’ve seen US interest rates going lower in general, but also the US curve steepening as well.
Greg Bonnell – The bond market seemed to cast its vote as to what kind of report this was because we are seeing those yields pull back across the curve. Jerome Powell was giving testimony in Washington this week, and I believe one of the things he said was they were pleased with the May report. And so I think there’s some thinking out there, well, if you’re pleased with May, the Fed should really be pleased with June. How does this start setting them up? I mean, is the door opening wider to a rate cut in the coming months?
Sam Chai – So I think this report definitely gives the Fed even more confidence that the disinflation narrative is in place. And you mentioned about the testimony that Powell gave in the two days prior. Even before this inflation print, Powell was already starting mentioning about there’s more balance of risk between the dual mandates of the Fed. And when you compare — and you look at the numbers, right? For Q2, the three-month annualized core inflation is at 4.5% — sorry, in Q1.
In Q2 now, it is 2.1%, so very meaningful progress, and does give Fed more confidence that inflation is indeed coming down. So, in terms of policy implications, would this rush event to deliver a cut in July? Possibly no. Labor market remains resilient. The core inflation rate remains above that target, so there is no rush to doing anything right now. But I think what it does is that it allows the Fed to turn incrementally more dovish in July and potentially set up for a rate cut in September.
Is September a done deal? Not absolutely, not 100%. We still get two more set of labor and CPI data from July to September. But I would say that the bar for those data to beat to invalidate the disinflation trend is very high, given how much disinflation progress we’ve already seen through the Q2 times. And so, overall, the Fed likely going to be very much more encouraged and likely that a September rate cut being the base case.
But, from September onward, assuming that there is a rate cut, what’s likely going to happen for our base case is a more gradual easing cycle. The Fed is likely going to be continuing to be data-dependent and continuing to be very mindful of the two-sided risk, their dual mandate, upside inflation risk versus downside growth risk.
Greg Bonnell – When we talk about fixed income and investors in that space, I feel they have been waiting for a while. Obviously, we’re starting to see the signs. What does it mean for the fixed-income investor, for the bond market?
Sam Chai – So this is definitely an encouraging sign that the Fed is finally ready to enter into, potentially, the easing phase of the monetary policy cycle. Well, the Fed has been postponing the rate cuts. People are waiting since March, like, when’s the cut coming? When’s the cut coming? And in Q1, we had seen the disinflation narrative being derooted, but now it has been reingrained.
And just from positioning, from flows, we’ve been seeing more fixed-income investors being willing to come back to the space and basically being more overweight on duration front. But the general narrative, again, this just cements the fact that an easing cycle is likely coming closer.
Greg Bonnell – Now, of course, as we wait for that easing cycle, that seems to be coming closer. People who have been fixed-income investors are still getting that yield. They’re getting a yield they haven’t seen in quite some time. I know we don’t have a crystal ball, but when we look back on 2024, six months from now, what kind of year is it going to look like for a fixed-income investor? Granted, these themes continue on.
Sam Chai – So, this year, the total returns for the fixed income in the US, on the government bond side, has been slightly positive. But we are seeing more encouraging signs on the data front. Obviously, disinflation trend, but also, we’ve been seeing some moderation in economic activity data as well, and that’s supportive for fixed income. So, for the remainder of this year, the expectation’s that we’ll likely be getting the income from fixed-income side, but potentially, we could also get some mark-to-market capital returns on fixed income as well.
So I think, needless to say, the second half of the year will be more encouraging than the first half of the year for fixed income.
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