Inflation Drivers

Inflation remains above target and is being driven by identifiable, but still unresolved, forces. Tariffs account for a significant share of core inflation and are taking longer than expected to pass through the economy. According to Powell, goods inflation has shifted from being flat or negative before tariffs to running around 2%, with tariffs contributing approximately 0.5 to 0.75 percentage points to the ongoing inflation overshoot.

Inflation has now run above target for five years, increasing concern as a new price shock from war has pushed oil prices higher. Powell acknowledged that the war against Iran has pushed up near-term inflation expectations. He also cautioned that the size and duration of oil’s impact on inflation is uncertain.

Powell expressed frustration with the stickiness of core non-housing services inflation. The labor market is no longer generating inflationary pressure yet services inflation has not declined accordingly.

The added uncertainty from war and oil reduces confidence in any forecasts. Powell acknowledged the lack of confidence behind them, noting that participants are effectively making estimates without strong conviction. He quipped that “you gotta write something down.” He even shared that someone on the FOMC joked that “This is one of those SEPs [Summary of Economic Projections], where if we were ever to skip an SEP, this would be a good one.”

Powell summarized the situation plainly: “the thing I really want to emphasize is that nobody knows.”

(Uncertain) Economic Backdrop

Still, Powell insisted that the broader economy remains resilient, with steady growth and stable unemployment. Longer-term inflation expectations remain anchored near 2%, which continues to provide an important foundation for policy.

The current SEP reflects low conviction and high uncertainty. Inflation’s trajectory will depend on how tariff effects resolve, how energy prices evolve, and whether services inflation begins to improve.

In the meantime, the Fed as a group still has core PCE (Personal Consumption Expenditure) inflation gliding comfortably to the Fed’s target of 2% by 2028 despite the recent updrift in the Fed’s preferred inflation gauge. Thus, the Fed remains confident in the path for the economy despite the lack of conviction in the forecasts.

The post Powell: Inflation Is Uncertain and the Forecasts Lack Conviction appeared first on Inflation Watch.

These graphs show a clear victory over inflation. Still, the 70% confidence interval remains wide over a range from close to 0% to 4%.

Gold Disagrees

Gold disagrees with the Fed’s inflation victory. Gold bugs are likely staring at the top end of the PCE confidence range (or even higher!). Gold is the most interesting contradictory signal for the Fed’s victory because it has easily outperformed the S&P 500 (SPY) this year. The SPDR Gold Trust (GLD) is up 26.7% year-to-date; this performance well outpaces the S&P 500’s 19.6% gain for the year. Gold can of course gain favor for a variety of reasons, but as long as rates are trending downward, I expect gold to continue higher. Notably, GLD bounced back sharply after its initial post-Fed fade and closed last week at a fresh all-time high.

The Wary Bond Market

The bond market looks a little wary about the Fed’s presumed victory. The iShares 20+ Year Treasury Bond ETF (TLT), which goes up when long-term interest rates go down, rallied into the Fed’s announcement on monetary policy. However, TLT gapped down ahead of the news and closed lower. TLT continued lower the rest of the week. It is possible the bond market got ahead of itself in anticipating economic weakness and/or lower inflation. Either way, I am looking at the technicals of TLT and see the confirmation of a (horizontal) presumed trading range. This trading range is working against the steep uptrend in the 20-day moving average (the dotted line in the chart below) and the 50-day moving average (the red line in the chart below). Thus, some kind of trend change or resolution is likely on the way in coming weeks. The outcome may sway my interpretation of the Fed’s inflation victory.

Bowman Disagrees

Both gold and the bond market could even take cues from the one dissenting voice on the Fed. On Friday, Governor Michelle W. Bowman explained why she only wanted a 25 basis point cut: “We have not yet achieved our inflation goal.” In particular, Bowman worries the 50 basis point cut “could be interpreted as a premature declaration of victory on our price stability mandate.” Bowman is not ready to declare victory.

The next Fed meeting is not until November. There is a lot of time ahead for Fedspeak to lean against any excessive victory celebrations in the financial markets. I will keep an interested eye on the market’s reaction to sobering words of caution and restraint.

The U.S. Dollar Hangs in the Balance

The Fed’s implied victory over inflation is also the U.S. dollar’s loss. The Fed is a bit late in lowering interest rates relative to several of its peers. The European Central Bank (ECB), the Bank of England (BoE), and the Bank of Canada (BoC) each dared to lower rates ahead of the Fed’s move. Yet, currency markets stayed keenly focused on coming rate cuts from the Fed such that the U.S. dollar weakened against each of the related currencies even as other banks fell one-by-one.

The British pound, Invesco CurrencyShares® British Pound Sterling Trust (FXB), benefited the most from dollar weakness of the currencies that are in the middle of rate cut cycles. Last week, FXB broke out to a fresh 31-month high. The weekly chart below shows FXB has room to recover back to its highs from 2021. Such a run is in the cards if Fed rate cut expectations continue to point lower.

I want to get more bullish on the Canadian dollar, but Invesco CurrencyShares® Canadian Dollar Trust (FXC) barely shows signs of life. FXC is scraping along a bottom that has served as support since the lows of 2022. If FXC hurdles over the previous weekly high, I will get more constructive. In the meantime, it seems the Canadian dollar is captured by a fate similar to the U.S. dollar (DXY).

The Victory Trade

So far, the Fed’s victory over inflation looks like victory for gold and the British pound. The story from the stock market is mixed. While the S&P 500 is back to an all-time high, the NASDAQ remains below a bearish topping pattern. Small caps are languishing. I do not expect the story to get clearer during October given its reputation as one of the stock market’s most dangerous months. Thus I am (short-term) neutral on the stock market as a whole while I remain (perma) bullish on gold. Gold is my inflation victory trade.

Be careful out there!

Full disclosure: long GLD, long SPY put spread, long QQQ put spread, net long USD

The post What A Victory Over Inflation Looks Like to the Federal Reserve appeared first on Inflation Watch.

Most telling in today’s performance was Powell’s dance around the questions trying to reconcile the economic forecasts with the rate forecasts. They seem inconsistent at best and make little sense at worst: one rate cut and no further progress on inflation (core PCE (Personal Consumption Expenditures)). The quotes below come from Powell’s introductory remarks.

• A midpoint expectation for one rate cut in 2024: “If the economy evolves as expected, the median participant projects that the appropriate level of the federal funds rate will be 5.1 percent at the end of this year, 4.1 percent at the end of 2025, and 3.1 percent at the end of 2026.” Note that the current rate is set to 5.25% to 5.50%. March’s median projection was 4.6% for year-end.
• Core PCE projection for 2024 increased from March’s 2.6% to 2.8% for 2024 and going to 2.0% in 2026. Core PCE has shown no downward momentum yet this year. It has gone from 2.9% in January to 2.8% from February through April. Thus, the Fed expects no further progress on inflation this year.
• The Fed made no changes to its GDP growth forecasts: 2.1% this year, and 2.0% for the next two years.
• The Fed made a slight change to its unemployment forecast. This year stayed at 4.0%. The rate went from 4.1% to 4.2% next year and from 4.0% to 4.1% in 2026.

Put it all together, and it is not clear why the Fed wants to cut rates at all this year. I made this point last month in “Fed’s Powell Avoids Rate Cut Talk While April CPI Keeps Hope Alive” and in March in “Financial Conditions Make A Monetary Roundtrip and Undercut the Need for Rate Cuts“. Now, with no forecasted progress in core PCE inflation for this year, the Fed seems to risk sticky inflation staying sticky for longer if it cuts rates before seeing the “sustained progress” Powell talks about ad nauseam. In this latest round, Powell repeated the policy principle yet again: “we don’t think it’ll be appropriate to reduce rates and begin to loosen policy until we have more confidence that inflation is moving back down to 2% on a on a sustainable basis and that’s the that’s the test we’ve applied”.

When Powell was asked about the conundrum, I expected him to untangle the problem by indicating these forecasts are interdependent and assume that the underlying economic mechanisms that connect all these factors work out as expected. For example, one hypothetical would be a world without a rate cut in 2024 which undermines the rosy projections for GDP and employment. Instead, Powell essentially undermined the meaningfulness of the forecasts.

Powell began by explaining away the sticky core PCE with a technical discussion about lapping lower readings from last year. He essentially suggested that the sticky core PCE is an artifact of tough comparables and thus not as meaningful as it seems at first glance. More baffling was Powell’s attempt to reconcile a year-end forecast that is higher than analyst forecasts for core PCE in May while at the same time forecasting a rate cut:

“it’s a forecast a fairly conservative forecast month by month that would lead to slightly higher…12 months rates by the end of the year if we get…better ratings than that then you will see that come down or remain the same. If you’re at 2.6 2.7 [for May] you know that’s that’s a really good place to be.”

In other words, this last lonely rate cut rushing toward the departure gate looks like the Fed’s fleeting attempt to throw the market a bone and deliver permission to continue to rally in anticipation of a rate cut cycle.

The Teflon S&P 500

The S&P 500 went into the Fed announcement at all-time highs and trading well above its upper Bollinger Band (BB) (the black lines defining price volatility in the chart below). From a technical perspective the S&P 500 is in an extremely stretched position to the upside. The small fade into the close still left the index quite stretched (short-term) to the upside.

The market gapped up in the morning presumably on a favorable print for the CPI (Consumer Price Index). However, while Powell acknowledged the positive development, he still threw cold water on the idea that this report finally gave the Fed permission to proceed with rate cuts:

“…we see today’s report as progress and as you know building confidence, but we we don’t see ourselves as having the confidence…that would warrant beginning to loosen policy.”

I am impressed the S&P 500 held on to any gains for the day. Then again, the index, and the stock market in general, has over the course of time acted like teflon against the on-going slippage in the forecast for lower rates.

The Trapped Bond Market

The stock market’s teflon has occasionally emerged tarnished by rising long-term bond yields. The breakout (lower yields) for iShares 20+ Year Treasury Bond ETF (TLT) earlier in June paved the way for the latest phase in the stock market’s rally. Yet, the S&P 500 did not come down with a pullback to the previous downtrend channel. TLT’s fade from last week’s high, as Powell made the case for a dovish hawkishness, may set the stage for a new trading range that traps the bond market in a new sideways trading channel. If so, the S&P 500 can detach more clearly from the machinations in yields. To-date, the on-going expectations for rate cuts has been an important driver helping the S&P 500 eventually recover from fears over long-term bond yields even as market breadth has waned.

In the meantime, I bought TLT put options as a trade on the presumed, new range.

Be careful out there!

Full disclosure: long TLT puts, long SPY puts and put spread

The post Fed’s Powell Avoids the Obvious: Inflation and Interest Rate Forecasts Make Little Sense appeared first on Inflation Watch.