At first glance, inflationary risks remain under control despite chaotic trade wars. Inflation rate increased from 2.3% in April to 2.7% in July, missing analyst estimates. As a result, traders increased their bets on dovish Fed and prepared for an inevitable rate cut at the next Fed meeting in September.
The producer prices (PPI) report for July has shaken this confidence. The report showed that PPI increased by 3.3% year-over-year, well above analyst expectations. The likelihood of the rate cut in September has decreased, although markets believe that Powell will continue the rate cut cycle under pressure from the Oval Office.
The key problem is that rising producer prices may lead to higher inflation, forcing the Fed to be more hawkish than previously expected.
That said, rising PPI does not guarantee a corresponding increase in consumer prices (CPI). Depending on the market situation, the whole supply chain may be unable to pass rising prices from producers to consumers.
Let’s take a look at CPI and PPI dynamics during the coronavirus pandemic, which led to high inflation. PPI peaked in March 2022 (11.7%), while CPI peaked in June 2022 (9.1%).
Thus, the peak in CPI lagged the peak in PPI by a couple of months. This is not surprising as it takes time for producer prices to be passed through the supply chain to impact consumer prices. Also, PPI peaked at higher levels than CPI, which means that producers had to take a hit on their profit margins.
With this in mind, we can expect CPI to rise in September. Importantly, the Fed meeting (September 16-17) would have already taken place by the time the CPI report for September is released. Thus, Powell will have to make a decision without access to full inflation data for September.
Will the markets fear that rising inflation leads to hawkish Fed policy? Such concerns are valid in the short term. Perhaps, some investors will use them as an excuse to take some profits off the table.
Cryptos, U.S. stocks and gold have shown great results since the start of the year, so taking profits ahead of the Fed meeting may look like an attractive idea for many investors and traders.
In the long-term, markets will ignore short-term fluctuations in inflation numbers and focus on important developments. Trump plans to replace Powell by someone loyal who will likely pursue dovish policy regardless of real inflation data. Concerns about the ultimate outcome of such Fed policy will support demand for assets, and the flight from fiat will continue.