Inflation surprise could change the game for interest rates

The US appears to have finally passed peak inflation, raising the prospect that the path of future interest rate rises there and elsewhere might be shorter and less steep than previously expected.

It is, of course, premature to declare victory on the basis of a single month’s numbers but the underlying influences on the fall in America’s headline inflation rate from a 41-year high of 9.1 per cent in June to 8.5 per cent in July were encouraging.

The sharp drop in inflation is encouraging news for the US and the rest of the world. Credit:Bloomberg

The biggest factor has been the fall in oil prices from more than $US120 a barrel in June to below $US100 a barrel in July. That will have an even more pronounced impact on the next US – and other – inflation readings. Declines in travel-related costs, clothing and education also contributed to the easing of the rate.

While the core inflation rate – excluding fuel and food costs – rose 0.3 per cent, that also undershot expectations and represented a slowing of the rate from the 0.7 per cent increase reported in June.

Perhaps the most encouraging recent data that helps explain why inflation might have peaked are signs that the global supply chain dysfunction that has been a key driver in global inflation rates rising to levels not seen in decades is easing.

The New York Federal Reserve Bank produces an index of global supply chain pressures. Its most recent reading shows a sharp fall in the index, driven by a dramatic reduction in shipping costs. The cost of shipping a container from China to the west coast of the US has tumbled from more than $US18,000 ($25,460) a year ago to about $US6,600.

This augers well for other economies, like Australia’s, that have been buffeted by the same post-pandemic tides as the US, although the continuing war in Ukraine will continue to keep energy and food prices relatively high.

The inflation data was greeted enthusiastically by financial markets, with the US sharemarket rising more than two per cent and bond yields easing. The tech-laden Nasdaq market was up 2.9 per cent and has now bounced more than 20 per cent since its mid-June lows, although it is still more than 18 per cent off the level at which it started the year.

Yields on 10-year bonds were touching 3.5 per cent in mid-June but have now fallen back below 2.8 per cent. The yields on two-year notes edged down but, at 3.21 per cent, the US yield curve is still inverted and still signalling, if not a recession, then a continuing slowing of activity.

The markets’ responses were driven by an optimistic assessment of the implications of the data for future US rate rises. The odds of the Fed raising its federal funds rate by a third consecutive 75 basis points next month lengthened and the likelihood of the next few increases being a less-confronting 50 basis points shortened.

Wall Street surged higher on the report.Credit:AP

Fed officials, however, have remained quite hawkish, perhaps because they don’t want to risk reversing the recent decline in US consumer and business expectations of future inflation. Whether it’s 75 basis points in September or 50 basis points, the messaging from the Fed is that there will be more rates rises in the US this year and into the early months of next year at least.

The slight cooling of the red-hot inflation rate last month is a step in the right direction but inflation in the US, and elsewhere, remains intolerably high.

There are also early indications of wages increasing in a very tight US employment market – unemployment is only 3.5 per cent – which will make the Fed and other central banks facing very similar circumstances cautious about taking their feet off the brakes too soon.

The prospect of some tapering of the likely path of Fed rate rises led to a slight softening of the US dollar against other major currencies. The dollar has depreciated about 3 per cent against the basket of its major trading partners in the past month – and almost five per cent against the Australian dollar – as interest rate differentials have started to close.

While the apparent peaking of the US inflation rate proffers hope that the Fed and its peers elsewhere might be able to engineer “softish” landings for their economies, there is no guarantee that they can finesse their monetary policies to achieve best-case outcomes.

That will come as a relief to other central banks, including the Reserve Bank, worried about capital outflows and imported inflation if the US dollar continued to strengthen. The relationship between the Australian and US dollars is a key influence on the RBA’s monetary policies.

The caveats within any assessment of inflation rates is the geopolitical turbulence. The war in Ukraine has caused an energy crisis in Europe that, with the northern winter approaching, can’t be completely resolved and which is having international spillover effects, particularly on the LNG market.

The proposed US and European-imposed price caps on Russian oil exports could lead to Russia simply withdrawing its oil from the international market. Oil and petrol prices would then soar again.

China’s sabre rattling in the Taiwan Strait could disrupt international shipping and add to the shortfalls in the global supply of semiconductors that have plagued industrial production generally, and globally, since the onset of the pandemic. Taiwan is a key global manufacturer of the chips.

There are signs that the global supply chain dysfunction that has been a key driver in global inflation rates rising to levels not seen in decades is easing.Credit:Bloomberg

Those are just some of the obvious things that could adversely impact inflation rates and undermine the increased optimism in financial markets.

While the apparent peaking of the US inflation rate proffers hope that the Fed and its peers elsewhere might be able to engineer “softish” landings for their economies, there is no guarantee that they can finesse their monetary policies to achieve best-case outcomes.

Given that most of the major central banks target inflation rates of between two and three per cent there’s a long way to go, and many more central bank rate hikes, before success, if achieved, could be declared and a lot of potential for policy mistakes in either direction.

Nevertheless, any reduction in what had been rapidly swelling US inflation is better than the alternative, and not just for America and Americans given the influence of US financial settings and markets on the rest of the world.

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