Any hopes of a Fed pivot were dealt a heavy blow last week when the latest Consumer Price Index (CPI) data showed month-on-month inflation accelerating to its highest rate in more than a year. The CPI, a measure of the average price level for goods and services in an economy, recorded a 0.6% increase from July to August, putting an end to the disinflation narrative that had been circulating in the financial markets in recent months.
The headline CPI number was fueled by a jump in energy prices, particularly gasoline, which accounted for over half of the monthly increase. However, core inflation, which excludes volatile food and energy prices, also ticked up 0.3%, exceeding economists’ expectations and adding further evidence to the reflationary trend. Core PPI, a measure of what businesses are paying for the goods and services they buy, also rose 1.6% in August, after bottoming out in June.
The latest inflation data suggests that the Fed’s fight against inflation is far from over as consumer price pressures remain firmly entrenched in the U.S. economy. Any notion that the Fed is done with raising interest rates has been put to rest by these figures, and much of the rhetoric from overly optimistic officials will have to be re-examined in light of the latest developments. With markets now pricing in at least one more rate hike this year, the Fed will certainly have to be more judicious in its approach going forward. Whether or not this latest round of data will be enough to shift market sentiment in a more hawkish direction remains to be seen.
A Closer Look into CPI Figures
According to the Bureau of Labor Statistics, the August CPI report showed that month-on-month energy prices climbed 5.6%, accounting for a large chunk of the headline increase. Gasoline prices alone saw an increase of 10.6%, while food prices rose by 0.2%. Housing costs, which account for almost 40% of the overall CPI basket, rose 0.3% month-on-month, bringing the 12-month housing inflation rate to 7.3%.
While the White House has been quick to draw attention to the less volatile core CPI data, the underlying figures still point to an increasing inflationary pressure. Core prices have been rising at an average of 0.35% per month since the beginning of the year and are now up 4.3% year-on-year — well above the Fed’s target rate of 2%. “Today’s report was a disappointment — not because headline inflation jumped, much of which can be explained by an increase in gas prices, but because core inflation moved higher by 0.3%, which was higher than expected,” explained Chris Zaccarelli, Chief Investment Officer for Independent Advisor Alliance.
The sticky core prices suggest that the underlying trend of rising inflation is unlikely to abate anytime soon. Although oil prices are stripped out of the core inflation calculation, the recent surge in gas prices has had a ripple effect across other sectors, raising concerns over business profitability. Higher gas prices push up the cost of inputs, which in turn forces companies to raise prices, creating a cycle of price increases that can further exacerbate the inflationary pressures. Airfares, for example, climbed 4.9% in August, underscoring the impact of rising energy prices on consumer prices.
With the OPEC+ members agreeing to cut oil outputs by 3.66 million barrels per day in 2023, oil prices have surged, climbing to their highest level this year. According to the International Energy Agency (IEA), Russia and Saudi Arabia’s agreement to extend production cuts “will drive a significant supply shortfall through the fourth quarter.” The cuts are expected to result in a “substantial market deficit” in the supply-demand balance, with analysts’ forecasts indicating that prices could rise further. “Should OPEC+ maintain the ongoing supply cuts through year-end against Asia’s positive demand backdrop, we now believe Brent prices could spike past $100/bbl before 2024,” said Francisco Blanch with Bank of America.
The prospect of further oil price increases is likely to add fuel to the already-hot inflationary fire according to experts — an unwelcome development for the Fed as it grapples with the reflationary forces that threaten to derail its policy objectives. But with many Americans already feeling the pinch from rising prices, higher inflation could force the central bank to act sooner and with more vigor than previously anticipated. This could mean a further reduction in the Fed’s balance sheet and an earlier increase in overnight borrowing costs, both of which could have far-reaching implications for the broader economy.
Nowhere to Turn for the Fed
In light of the latest CPI report, the Fed faces a difficult decision as it seeks to balance its dual mandate of maximum employment and price stability. While officials may be loath to raise rates again before 2024, an overly dovish stance could fuel further inflationary pressures. This in turn could undermine the credibility and effectiveness of monetary policy as investors begin to question the central bank’s resolve in fighting inflation, according to experts.
According to the CME Group’s Fedwatch tool, the probability of a rate hike in September is only 3%, but with inflationary forces gathering steam, the prospect of at least one more rate hike before the end of 2023 has nearly doubled. Though the exact timing and size of any rate increases remain uncertain, the recent CPI report has thrown the Fed’s decision-making process into sharp relief, forcing it to grapple with the consequences of its past decisions. As Jason Pride, chief investment officer for private wealth at Glenmede, remarked, “getting the inflation genie back in the bottle does not appear as straightforward as some would have hoped.” With inflation being thrust back into the spotlight, the central bank is now left with few options and limited room to maneuver.
If the Fed fails to act swiftly and decisively to address rising inflationary pressures, the consequences could be dire, say some experts. Prices could spiral out of control, sparking a new round of economic woes and undoing much of the progress the central bank has made in recent months. Fed hawks also warn that a delay in raising rates would further erode public confidence in the central bank’s ability to manage inflation, compromising its credibility and making it more challenging to hit its targets in the future. But, according to some economists, even the 0.25% rate hike that the Fed is widely expected to approve in the coming months won’t be enough to stem inflationary pressures. “To tame inflation, the government needs to cut spending,” warned economist Peter Schiff in reference to the government’s growing outlays and shrinking revenues.
The problem with raising rates is that it could further squeeze businesses, disrupt financial markets, and derail economic recovery. Fed Doves point to the potential risks to the US economy from higher borrowing costs, warning that a misstep now could spark a recession and deepen the woes of the US economy. Corporate interest rates have climbed by more than 22% over the past two years, squeezing the profit margins of companies already struggling to keep their businesses afloat. With corporate bankruptcies rising at the fastest rate since 2010, excluding Covid-related bankruptcies, the Fed risks exacerbating an already-volatile situation should it move too fast. As overstretched borrowers struggle to cope with higher borrowing costs, defaults could soar, leading to losses for banks and financial institutions. With the banking industry already on fragile footing in the wake of the banking crisis earlier this year, any further losses could tip the sector into a tailspin. Should this happen, the Fed may well find itself in a predicament that it can neither control nor reverse.
The Case for Gold
With the Fed painted into a corner, many savers have begun seeking out defensive assets to help provide a measure of protection against higher inflation. According to JPMorgan, gold is poised to break through the $2,000 per ounce mark by the end of the year, propelled by robust demand as investors seek refuge from an uncertain economic environment. “We’re in a very prime place where we think gold ownership and long allocation to gold and silver is something that acts as both a late cycle diversifier and something that will perform as we look to the next sort of 12, 18 months,” said Greg Shearer, executive director with JPMorgan. The precious metal has seen its price surge by over 15% this year alone amid rising central bank buying and an increased appetite for alternatives to the US dollar. Apart from gold, other precious metals have also been gaining ground, with silver prices climbing 18% in the past 12 months.
The allure of precious metals extends beyond inflation hedging, however. Gold and silver have long been prized for their scarcity and durability, making them attractive storehouses of long-term wealth. And because they exhibit a low correlation with other asset classes, experts say they can provide an added layer of diversification for portfolios. As the Fed continues to grapple with how to address the looming inflationary threat amid signs of a recession on the horizon, a flight to gold and silver could offer savers much-needed respite. “There’s an eagerness here to really buy in and diversify allocation away from currencies,” stated Shearer, who sees the precious metals as being well-positioned to gain from current macroeconomic conditions. With the US economy on a knife edge and the Fed seemingly out of options, gold and silver may prove to be a lifeline for Americans looking to help protect their savings.
