The U.S. economy continues to move forward despite the fastest-ever cycle of rate hikes. The European and Chinese economies could be doing better, but the latter has a greater ability to force a reversal.
Key Takeaways
- U.S. CPI fell again and is now at its lowest yearly rate since March 2021. Rising oil prices may push CPI higher in the short term.
- The Fed rose interest rates again and has arguably done enough. However, it is limited to only being able to look in the rear-view mirror.
- The European and Chinese economies are underperforming. Notably, last week, China pledged to step up stimulus measures.
U.S. CPI Falls to 3.0%, Lowest Yearly Rate Since March 2021
In June, the U.S. consumer price index (CPI) rose by 0.2%, the lowest since March 2021, with a year-on-year increase of 3.0%. Core CPI, which excludes food and energy, increased by 0.2% on a monthly basis and 4.8% on a yearly basis.
The lower inflation rate was influenced by soft gains in food prices and declines in used vehicle and airline prices, while shelter prices continued to rise. Adjusted for inflation, worker wages saw a 1.2% increase from a year ago.
Easing inflation (i.e. disinflation) could provide some relief to the Federal Reserve (Fed) in its efforts to contain price rises. Despite the lower headline inflation, core inflation remains above the Fed’s 2% annual target. Fed officials expect the inflation rate to continue falling, particularly with easing rental costs—a significant component of the CPI. However, house prices are not decreasing significantly, affecting inflation, and limiting supply due to homeowners’ reluctance to sell in response to rate increases.
The Fed Raises Rates to 22-Year High, May Raise Again By Year-End
In late July, the Fed raised interest rates by 25 basis points to a range of 5.25–5.50%. This was the Fed’s eleventh hike in its last 12 meetings.
Chairman Powell emphasised the need for the economy and labour market to weaken for inflation to return to the Fed’s 2% target. The Fed left its policy options open and stated that it would continue assessing incoming data before deciding on further rate increases, with the next meeting in September being considered a possibility for another hike.
Powell was encouraged by the fact that falling inflation has yet to significantly damage the economy. Still, he believes that achieving the target inflation rate might require a period of below-trend growth and a softer labour market. While some policymakers anticipate the need for more rate increases this year to curb inflation, others cautioned against expecting any near-term rate decreases. The Fed’s focus remains on closely monitoring incoming data to gauge the economic impact of its rate hikes before making further decisions.
Oil Price Continues to Climb, Hurting Efforts to Curb Inflation
Oil prices reached a 3-month high in July, driven by signals of tightening supplies and China’s pledge to support their economy. The market showed concerns over output cuts from OPEC and allies, leading to a price structure known as backwardation, where futures trade below spot.
Gasoline or petrol prices have surged to 8-month highs in the U.S. due to excessive heat and production caps affecting supply. The U.S. average for regular gasoline reached $3.71 per gallon, the highest since November 2022. Higher oil prices drive the spike, OPEC’s production cuts, and unscheduled refinery maintenance during extreme heat, limiting gasoline supply when summer demand is high. Bank of America warned of a potential supply deficit in the oil market in the second half of the year. If sustained, higher gasoline prices could complicate economic matters by impacting inflation and consumer confidence.
Europe’s Economy Continues to Struggle
Business activity in the eurozone shrank more than anticipated in July, with the services industry and factor output falling at their fastest rates since the onset of COVID. Germany and France, the zone’s two largest economies, reported declines, raising recessionary fears. Some analysts argue the eurozone is already in a recession.
The European Central Bank’s sustained campaign of interest-rate increases is also impacting consumers and denting the services sector, prompting questions about its approach to balancing the fight against record inflation and potential economic damage.
The eurozone’s Purchasing Managers’ Index (PMI), an important measure of overall economic health, fell to an 8-month low of 48.9 in July (50 is neutral). While the downturn was widespread across sectors, manufacturing was particularly weak. This indicates a deterioration in macroeconomic conditions and a greater risk of a small contraction in eurozone GDP in Q3.
The services PMI fell to 51.1 from 52.0, while the manufacturing PMI declined to 42.7 from 43.4. Despite manufacturers running down backlogs of work and cutting prices, the output index hit its lowest level in over 3 years.
The eurozone’s private sector is facing challenges due to weaker consumer spending caused by higher borrowing costs and prices. The ECB’s struggle to bring inflation back to its 2% target, despite aggressive tightening policies, raises questions over how additional rate hikes would impact consumers.
China to Step Up Stimulus Amid Sluggish Economic Recovery
China’s top leaders, including President Xi Jinping, pledged in late July to enhance policy support to combat its economy’s sluggish post-COVID recovery. It will focus on stimulating domestic demand and implementing counter-cyclical adjustments through prudent monetary and proactive fiscal policies.
Despite facing difficulties in operating some enterprises and a complex external environment, the government aims to achieve its annual development targets.
One stimulatory measure being taken by the Chinese government is to increase residents’ incomes. Additionally, they will speed up local bond issuance to encourage investment and promote sectors such as autos, electronics, household products and tourism. Recognising the significance of the property market in the current economic situation, property policies will be optimised in response to changes in supply and demand relationships.
The government will also focus on supporting the private sector’s growth by making it “bigger, better, and stronger” through various guidelines and initiatives. While analysts expect further stimulatory policy measures in the coming months, their aggressiveness may be limited due to growing concerns over heightened debt risks in China.
Tying It All Together
The market has been front-running the Fed all year, expecting fewer rate hikes than what the Fed has indicated. The Fed has resisted changing course prematurely and reiterated the possibility of further rate rises. While wage growth has alleviated some concerns, oil prices have climbed, leading to higher gasoline prices. Since oil directly impacts all goods prices, down-trending CPI may reverse in the short term.
Moreover, major companies (e.g. Microsoft, Alphabet) have posted stronger-than-expected Q2 earnings, indicating they still have some pricing power supporting the elevated services inflation.
The market is still trying to find opportunities by focusing on aspects such as the weakening U.S. dollar. Combined with no Fed meeting for the next 2 months and China’s stimulus, it wouldn’t be surprising to see another 1–2 months of upwards momentum. This is already the most hated rally because the price has exceeded fundamentals, so what’s a few more haters?
Recap
Price and fundamentals are rarely in sync over the short and medium term. Economic conditions in the U.S. are not overly rosy despite the possibility of a soft landing. The world is also interconnected in ways that are difficult to comprehend. A weakening eurozone may not lead to a global downturn if other countries are better equipped to drive economic growth.
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