The week in the markets -
June 16, 2023

The Fed responds as inflation continues to fall

• U.S. Federal Reserve on the tightrope, balancing economic indicators and sticky inflation.
• Consumer Price Index (CPI) slows in May.
   

U.S. inflation data for May came in much lower on a year-over-year basis, at 4%. This was modestly lower than expectations and the lowest level since March 2021. Core CPI, which excludes food and energy prices, has increased by 0.4% on a month-over-month basis for each of the last three consecutive months, signaling somewhat sticky inflationary pressures. Meanwhile, year-over-year core inflation came in at 5.3%. As inflation overall continues to decelerate, the slower path of descent for core inflation may present a more challenging dynamic for the U.S. Federal Reserve regarding the potential for further interest rate increases.

More importantly during the week, investors’ focus was on the U.S. Federal Reserve (the Fed) and a "will-they-won't-they" saga with interest rate hikes. Ultimately, the Fed decided to pause on any further hikes in this week’s meeting. After the supposedly “dovish hike” last meeting, the message was somewhat of a hawkish pause. Given the strength of the S&P 500 Index through the remainder of the week, we can only assume investors looked through the “hawkish pause” narrative and viewed the Fed’s pause as resolute. A pause is a pause and therefore cause for investor optimism. It remains to be seen whether this is a “skip-and-go,” or if the Fed is done with hikes for the time being.

This month's lower-than-expected CPI and Producer Price Index data could indicate that the Fed might be done. However, the overheated markets and robust retail sales don't necessarily suggest that inflation is under control, so the possibility of another hike in July is definitely not off the table. It's important to remember that inflation expectations can drive inflation higher, and the reverse is also true. So, even if the Fed feels like they can afford to be patient and stick with current rates for a while, their tone needs to remain strong if they don’t want to kick-start inflation by implying eventual cuts.

Our view remains that if we haven’t already seen peak interest rates, we are very close. The near-term challenge will be inflation, which we forecast to remain in the 3.5-4% range through the back half of 2023. The question is, will the Fed see through that and expect inflation to drop in 2024 or respond with further rate hikes in the fall?

On the energy front, inventories for crude oil, gasoline and related products increased much more than anticipated. The price of crude was highly volatile this week, with a combination of conflicting news. Strong Chinese demand and a weakening U.S. dollar made the inventory buildup less concerning for markets. Even though the Biden administration once again declared its intention to purchase up to 12 million barrels of oil to replenish the Strategic Petroleum Reserve, they still drained 1.9 million barrels last week, marking the 11th consecutive week of draws. Meanwhile, the International Energy Agency expects record demand growth this year and stated that it doesn’t foresee the transition to clean energy exerting a significant enough impact to decrease oil demand growth before 2028.