Yesterday's market movements followed the anticipated pattern, with a rally in bonds and foreign exchange (FX) after the release of the US core Consumer Price Index (CPI). The report, showing a 0.292% increase in core CPI, matched the consensus projections and offered some relief to traders. This led to gains in stocks, bonds, and FX that extended into the Asian markets overnight. However, European indexes stumbled this morning due to negative guidance from industrial companies and a recent slump in energy prices.
Implications of the US CPI Report
The US CPI report was significant because it marked the end of a series of higher-than-expected inflation readings that had begun in January. The April report showed a mix of positive and negative developments. On the positive side, there were notable declines in airfares, used and new car prices, and a slight easing in housing rents. Primary rents dropped to 0.35% from 0.41% in March, and Owners' Equivalent Rent (OER) moderated to 0.42% from 0.44%.
However, some components of inflation remained stubbornly high. Car insurance costs rose by 1.8%, adding to March's sharp increase, and discretionary spending on recreation services accelerated to 0.3% from 0.1% previously. These mixed signals suggest that while there are signs of easing inflation in some areas, other costs are still rising, complicating the overall picture.
The Federal Reserve (Fed) faces a challenging environment as it navigates these inflation dynamics. Despite the at-consensus core CPI print, it may not be sufficient to trigger a countdown to rate cuts. The core CPI's three-month annualized inflation rate stands at 4.1% as of April, which is still relatively high. Even if the core Personal Consumption Expenditures (PCE) Price Index for April comes in at an estimated 0.25%, it would translate to a three-month annualized core PCE inflation rate of 3.5%, still above the Fed's target.
Inflation Expectations and Future Fed Actions
One month of in-line core CPI data is unlikely to convince the Fed to start cutting rates. The Fed may need to see a more sustained trend of lower inflation before making such a move. Specifically, three consecutive months of core PCE inflation running at or below 0.17% may be required. Additionally, the Fed would want to see broad-based reductions in inflation, including in median inflation measures.
Furthermore, inflation expectations have risen slightly in April, according to consumer surveys from the New York Fed and the University of Michigan. Other indicators, such as the NFIB small business survey, also show stronger future inflation expectations compared to the pre-pandemic era. These factors suggest that the Fed remains cautious about the prospect of a rate cut in the near term.
The structural drivers of medium- and long-term inflation, such as de-globalization, climate volatility, and the push for decarbonization, could also pose challenges. For instance, the super-core CPI, a measure favored by some policymakers, was 0.42% in April, with a year-over-year increase of 4.9%. Rising auto insurance costs, partly due to higher expenses associated with electric vehicle repairs, are one example of how decarbonization efforts can exert upward pressure on inflation.
Given these complexities, Fed officials are likely to remain guarded in their public statements. Recent comments from New York Fed President John Williams reflect this cautious stance, and other Fed speakers are expected to echo similar sentiments.
Brazil's Political and Economic Landscape
Brazil's recent political developments have also impacted market dynamics. The Brazilian Real (BRL) weakened following news that Petrobras CEO Jean Paul Prates was dismissed, reportedly at the behest of President Luiz Inacio "Lula" da Silva. This move is seen as part of the government's efforts to exert greater control over Petrobras' dividend and fuel price policies, aiming to promote political goals such as job creation and inflation suppression.
Brazil's drift toward left-populism, while not inevitable, was predictable. It has been a key factor in the bearish outlook on the BRL. President Lula's administration faces challenges ahead of the municipal elections in October 2024, which could see a resurgence of right-wing forces. This political pressure has led to a weakening of Lula's commitment to free-market principles and has introduced uncertainty into Brazil's economic policies.
The firing of Petrobras' CEO is seen as a move to align the company's policies with the government's political objectives. This, along with other populist measures, creates periodic volatility in the USD/BRL exchange rate. Analysts predict that USD/BRL could rise to 5.20 by mid-2024 as traders anticipate these risks. If the political uncertainties persist, USD/BRL might end 2024 around 5.40, making short positions on USD/BRL less attractive.
Navigating Uncertainty
While the recent CPI report provided some relief to traders, it has not significantly altered the broader economic and political landscape. The Fed is likely to maintain a cautious stance, given the mixed inflation signals and structural challenges. Meanwhile, Brazil's political developments add another layer of uncertainty to global markets.