The latest U.S. CPI report came in cooler than expected, but does it mean the Fed will be slowing the pace of rate hikes? MoneyTalk’s Greg Bonnell speaks to Christian Medeiros, Portfolio Manager at TD Asset Management, about his outlook for inflation and interest rates.
Latest read on US inflation coming in lighter than expected, adding to investors' hopes that this recent run of aggressive Fed rate hikes may soon be coming to an end. Joining us now for his take, Christian Medeiros, portfolio manager at TD Asset Management. Christian, great to have you back, and great to have you back on a day like this, when we can really dig into the inflation report. What were you seeing in it?
Great to be back. Yeah, much lighter than consensus and much lighter than expected, both on headline and on core. As a result, markets are celebrating because it's moving in the right direction that Fed expects, as they expect their hiking campaign to push inflation closer to their 2% target.
What we see in markets is that they were pricing a lower terminal rate than we were yesterday and that terminal rate is happening sooner in the year than was expected. So market is expecting less of an aggressive Fed going forward. And this is opportune, as we have a meeting later this week. So as a result, we see stocks up, yields down, and the US dollar weaker. So strong risk on move across the board.
Does this feel like a bit of a one-two punch? I mean, one being the inflation report this morning comes in lighter than expected, you see a rally in the markets, but at the same time, I'm not entirely convinced what Jerome Powell is going to tell us tomorrow, in terms of what kind of central bank governor are we going to get on the back of-- or Fed chair, I should say-- on the back of this report. I mean, what will they make of it?
Mhm. So this inflation report is not likely to change the hike expected later this week. We'll still probably get that 50 basis points. But we do get economic projections from the Fed, and so people will be closely watching where the average expectation for a terminal rate will be and what their projections are for economic growth and key data points are from the Fed. So that will be one key thing to watch. Probably won't affect that, but that'll be really interesting for markets to interpret.
The main thing that I think investors are concerned about is how will the Fed, particularly Jerome Powell, speak about things in the press conference when he's answering Q&A. If we remember to the last press conference, he pushed back pretty strongly when he heard that markets were higher on the day just because he wants to keep financial conditions in line. So it is possible that the Fed will continue to toe the line on being a little bit hawkish, toe the line on ensuring that financial conditions stay moderate, because he doesn't want so much of a lightening of financial conditions that it undoes the positive progress that we're seeing in inflation.
Yeah, I had the exact same thought when I saw the markets pop on the back of the report before things calmed down a little bit. I thought, you're going to get stern Powell again. You got stern Powell at Jackson Hole. You said the last time we got stern Powell again because he wasn't happy with what he was seeing out there.
Mhm. Yeah, I think he'll be middle ground, try to play both sides, continue to press the agenda that we can expect the Fed to continue ongoing in its rate hike trajectory in order to get inflation under control. And we shouldn't expect the Fed to lighten up too much in the interim, as just a couple of months now of sequential improvements.
And they don't want to make the mistake of Arthur Burns back in the '70s of lightening up too early. So the messaging is really going to be about the pace, how much slower it's going to get, where the terminal rate will be, and how long they'll hold it there. These are the questions that investors will start to be asking.
Yeah, they need to see a longer-term trend, obviously, and that would make a lot of sense to hear that from them. Are we starting to see the seeds of that longer-term trend? Can we believe in the numbers that we've seen that have taken us at this point, that perhaps in 2023 we're in an environment where we do see inflation continue to work itself down and we don't have to deal with jumbo-sized rate hikes?
Yeah, so let's dig into the print, what we saw within inflation. So last time we spoke, we talked about the onion analogy that Governor Williams used. On the outer layer of that inflation onion is commodities and energy. We saw big declines in that again, so that's a great improvement.
Second layer would be durable goods and products. We actually saw quite big declines in that category this month. One really notable one was used cars. So if you remember back to the pandemic, everyone was bidding on used cars. Prices were much, much higher. As a result, new cars, also hard to get because of supply chain issues, prices for new cars were skyrocketing, as well.
We actually saw a big decline in used cars this month. We also saw new cars flat month over month. So this is actually quite a big improvement on durable goods. And other durable goods, like white goods, we also saw some moderation, as well. So that's great. That really shows that the goods supply chain portion of the inflation picture is moderating.
The center part of the onion, the toughest one to crack or cut through, is shelter and core services. We actually saw a bit of potential-- we can expect some improvement here, too. Still strong. We still see strong wages, which feed into this category. But we do see some improvement. I think the big thing that we can expect here that will lead to sequential improvement is on the shelter side, still the biggest portion of inflation.
But when we look at the leading indicators of shelter, such as Zillow rents, so what are the new rents in the economy month over month, we can see that that's declining quite quickly. The way it's measuring CPI is by far the most lagging because it's polling all the rents within the economy. And looking at the historic lead/lag relationship, maybe about 12 months.
So we saw those new rents declining in May this year. By May next year, we should start to see this category moderating, as well. So what that means is all layers of the onion, we can see a path to lower inflation over the course of 2023. What level we get to is the big question, but we can definitely see it moderating from here.
How does that set up the markets for 2023? If you can get past the jumbo-sized rate hikes, that there is some sort of effect to grind inflation down, even though it's going to be a process, and perhaps, as part of that process, the central banks eventually find their terminal rate and stay there for a while, how does that set us up as investors?
Yeah, given that we see a path of moderating inflation across the whole onion, if you will, we think that the story next year and the narrative next year might be a little bit different. We're moving away from the jumbo-sized hikes towards a slowing. And I think the questions will now move towards from inflation to growth. What will growth look like? Will the record pace of hiking that we've seen, will that lead to a recession? Will the declining goods economy that we're seeing in PMIs, will that lead to a recession in North America? Will it lead to a recession globally?
So these are the growth questions that I think investors will be asking next year. And that's going to really determine the path of markets, and also determine the path of interest rates. Right now, the market is predicting cuts in the latter part of 2023, which could indicate that the market is seeing potential softening. So I think that trajectory on recession is really the key thing to watch in '23, moving away from the inflation narrative.