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US CPI came in softer than expected, as measures of Core and Headline inflation moved lower on both an annual and month-over-month basis.
Data
Beneath the wraps, both goods and services are moving in the right direction, despite remaining above a level consistent with the Fed's mandate:
We anticipated an eventual cooldown in inflation due to lower commodity, logistics, and energy costs. Shelter inflation remains elevated despite market-based measures pointing to much lower y-o-y growth. Considering the 12-18 month lag between CPI measures of shelter inflation and market-based measures, we believe that there is a significant chance of inflation moving below 3.5% before the end of 1H 2023.
Moving forward, we believe the primary dynamic that will drive the inflation is the labor market and wage growth.
In economics, the Phillips Curve describes the inverse relationship between employment and inflation (labor market tightness = higher inflation, and vice versa), which is the basis for this perspective. With the labor market continuing to show resiliency, there is some worry that the Fed will need to engineer a recession in order to reduce the demand of labor.
From data we have studied, we believe that it is possible for wages to move lower without requiring a large increase in unemployment. However, visibility into this outcome is poor and we remain cautiously optimistic.
How does this set us up for tomorrow's FOMC meeting?
The Fed will likely raise interest rates by 50 basis points and communicate their preference to overtighten, in the face of still-high inflation. However, recent inflation data has given the Fed some breathing room to 1) slow down the pace of their hikes, and 2) communicate a terminal rate that is lower than expected (~4.8% to 5.25%).
How will this impact the market?
Equities are rallying and bond yields are coming in lower, so clearly the market sees this as positive for risk assets. As long as the market does not get too ahead of itself in expecting either rate cuts or a much lower terminal rate, we think this rally has legs to run.
Feel free to share any comments or questions.
Best regards,
Muhammad Wahdy
Portfolio Manager
Wahdy Capital
Email: wahdy@wahdycapital.com
BBG: mwahdy@bloomberg.net
Phone: +1-415-534-1435
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