The markets are suddenly exuberant: are they right?

Financial markets seem to have welcomed the latest inflation data from the United States (Reuters)

With the inflation crisis well into its second year, a few words have become entrenched in the investor lexicon. There were predictions of a “transient” problem, subsequently much ridiculed. There were also accurate forecasts about the “advance distribution” of interest rates by central banks and, more recently, complaints about the late and “expeditious” way in which the Federal Reserve of USA has addressed the tightening of monetary policy. Attention now turns to the concept of “fake head”: the notion that a rosy set of data suggesting a reversal in inflation may fuel a burst of optimism in markets, only for the sad reality of persistent price pressures to be reasserted.

At the end of last week, asset prices soared, buoyed by the latest inflation figures from USA. Stocks rose around the world. The nasdaqthe technological reference index of USA, rose nearly 10% on November 10 and 11, its biggest two-day gain in more than a decade. Depressed currencies such as the pound and the yen also recovered. Economists had expected the consumer price index for USA for the month of October it will increase by 0.6% compared to the previous month. Instead, according to figures published on November 10, it increased by 0.4%. This is a small difference in the grand scheme of things. In annual terms, it is equivalent to an inflation of almost 5%, well above the objective of the Federal Reserve of approximately 2%. But investors were quick to extrapolate the possibility that maybe – just maybe – inflation’s grip on the US economy was weakening.

Almost instantly, traders revised down their estimates for the interest rate spike. Before publication, many thought that the fed would raise rates to 5.5% in mid-2023. Now bond yields suggest 5% is more likely. This would have all sorts of positive consequences. It would reduce the probability of a crushing recession by USA and further, it would relieve pressure on other countries’ central banks to keep up with the Fed and boost the prices of risky assets, especially stocks.

Hence the question of whether the data equates to a false head. After all, investors got burned in the fall of last year, when inflation seemed to briefly peak, and again this July, when they prematurely concluded that the fed it was going to reduce the intensity of his hardening. Both times, the market gains fizzled out in no time.

Is this time different? The argument that price relief is finally within reach rests on two pillars. First, a wide range of products appears to have moved toward deflation. Commodity prices – excluding volatile food and energy – fell 0.4% mom in October. This partly reflects the disappearance of price increases from the time of the pandemic, such as those for used cars. But the declines were large: household furniture, clothing and school supplies became cheaper. And retailers are reporting rising inventories and lower consumer demand. The net effect appears to be an expected decline in commodity prices.

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The second pillar is a tantalizing sign that service prices are also heading in the right direction. The main driver of services inflation – housing costs – seems to be running out of steam a bit. The most important factor in determining the cost of housing in the CPI are the rentals, which accounted for more than half of the increase in core inflation in recent months. In October, rents increased 0.7% month-on-month, compared to 0.8% in September. This is significant because it suggests that the official estimates are going in the same direction as higher-frequency private-sector indicators, which have shown rental inflation slowing for almost half a year. A basic difference in methodology explains the gap: the private sector indicators are based on the sales price of properties on the market, while the official measure is based on rents paid by tenants, including rents under existing contracts. , often cheaper. Given this long lag, rents may be about to become a disinflation factor in the CPI.

paradise postponed

However, it is useful to check the reality. As last year’s experience shows, monthly figures can be noisy. And the fundamental problem in USA is the excess demand relative to supply. This problem is exacerbated in the labor market, where the extremely high job offers support strong wage increases. To curb inflation, the labor market must cool down.

The economy is already past the point where it can enjoy disinflation without collateral damage. In theory, it is possible for companies to reduce their hiring without pushing large numbers of people out of work. However, some increase in unemployment seems inevitable and, for the Federal Reserve, even desirable.

Also, the rise in equities is not welcome from the Fed’s point of view. Markets are the main transmission belt for monetary policy. A large rise in share prices represents an easing of financial conditions, which if sustained would make it easier for companies to obtain credit, running counter to the central bank’s efforts. Fed officials are deeply versed in the history of the 1970s, when the United States struggled with double-digit inflation, and when central bankers erred in easing policy as soon as pressures began to ease, allowing for inflation to roar again.

Jerome Powell, the chairman of the Fed, is determined to avoid a similar mistake. At a press conference on November 2, after the latest rate hike, he said no fewer than four times that the Fed still has “a ways to go.” This should serve as a warning to investors who are suddenly bullish. Even if the lower-than-expected inflation reading marks a turning point in the US battle against inflation, it will be a gradual turn, not a sharp turn.

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