Inflation/Deflation
This morning’s jobs report serves to underscore that the labor market is not a source of inflationary pressure and therefore of second-order importance when it comes to the Fed’s near-term decision making.
US bonds will likely continue selling off until tighter financial conditions – most plausibly a double-digit decline in the S&P 500 – cool nominal growth. Higher discount rates will threaten US equity valuations before earnings weaken. AI stocks will peak well ahead of AI capex. Remain downbeat on EM stocks.
Core US inflation is still running above target. But this morning’s data revisions reveal that the gap is not nearly as large as it appeared yesterday.
The Fed is unanimous in expecting a mild tightening cycle of no more than 75 bps, but that outcome is contingent on a rapid drop in core inflation in 2027.
The PCE/CPI gap is an increasingly important factor driving the near-term outlook for Fed policy. We discuss the drivers of that gap and conclude that it’s likely to narrow in the coming months.
July’s CPI reading was low enough to keep the Fed on hold for now, but near-term upside inflation risks remain.
Despite today’s hold, the bar for a rate hike in September remains low and contingent on the next two core CPI reports.
Most Fed and pundit assessments of inflation expectations are overly narrow, focusing too much on long-term market-based measures. We favor a more qualitative approach that asks whether the inflation outlook is influencing household and business decision making.
As long as the AI boom keeps booming, all other investment considerations will remain on the back burner. However, if the AI trade fizzles, this would expose deep-seated problems within the global economy, which could very well lead to an economic downturn as early as next year.