The Fed remains more skeptical and awaits evidence of services inflation turning a corner.
Asset performance since mid-October reflects growing confidence about the inflation outlook.
Chart 1 shows the returns accrued by the FT Wilshire 5000, US bonds and the US dollar from the low point reached on October 14th last year and performance YTD for 2023. While both equities and bonds have rallied strongly the dollar has fallen sharply. The common denominator between these divergent moves is growing conviction that US inflation has already peaked and that US interest rates will follow suit.
Chart 1: Move in US assets since October 14th low and YTD
Source: Wilshire, Refinitiv, FactSet. Data as of January 17, 2023
Key inflation gauges seem to have peaked several months ago
Chart 2 plots the key US inflation indicators and shows a profile of inflation peaking (and subsequently declining) over the last six months. In fact the Fed's key indicator the Core PCE deflator peaked in February 2022. It also appears that the Fed ramped up its hawkishness as evidence of the peak started to appear.
Chart 2: Key US inflation gauges appear to have peaked several months ago
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
However, the Fed is probably waiting for evidence of services inflation to peak
Chart 3 shows that the key driver behind the peak in inflation has been the rapidity of the decline in both goods inflation and input prices as measured by the PPI indicator. Services inflation has yet to peak, and the Fed will probably need to see this confirmed in subsequent data to change tack on interest rates.
Chart 3: Declining goods inflation but services inflation (the Fed's focus) remains elevated.
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
A gap between market and the Fed's interest rate curve forecasts - fade vs higher for longer
Chart 4 plots both the markets interest rate and Federal reserve dot plot curve forecasts. The market expects rates to peak close to 5% in Q2 but then to 'fade' lower into the second half of the year as growth headwinds and disinflationary pressures push rates lower. However, Fed forecasts paint a picture of continued increases throughout the course of the year reaching peak rate by the end of the year (higher for longer).
Chart 4: Mind the gap between the market and Fed interest rate forecasts
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
The Fed has started to 'taper' its hawkishness - impacting the dollar
While the Fed is still waiting for more evidence of inflation peaking it has been concerned that the deliver of restrictive financial conditions runs the risk of slowing the economy too aggressively and has subsequently started to rein in (taper) the scale of interest rate increases it is delivering at the FOMC meetings (see Chart 5). Tapering has been a contributory factor behind the weakening of the dollar.
Chart 5: The Fed is tapering the magnitude of rate hikes - impacting the dollar
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
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