Daily Comment (September 14, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment is split into three sections: 1) Why rising energy prices will complicate the Fed’s efforts to project future policy rates; 2) Why European policymakers may be finished with their hiking cycle; and 3) Why the green transition is leading governments to push for more domestic manufacturing.

Where Do They Stand? The disappointing consumer price index (CPI) report may lead to further divisions within the Federal Open Market Committee (FOMC).

  • Rising energy prices pushed headline CPI above expectations in August, leading investors to adjust their interest rate expectations. Consumer prices rose 3.7% from the previous year, above economists’ expectations of 3.5% and July’s reading of 3.3%. The rise was driven by a 5.6% surge in petrol prices from the previous month, which accounted for more than half of the month-over-month increase. Energy prices have picked up following efforts by Saudi Arabia and Russia to prop up oil prices through production cuts. The sudden reversal of inflationary pressures has led to investors’ pricing in a near 50% chance of another hike by the end of the year.
  • Despite the recent surge in headline inflation, there are some encouraging signs that underlying inflation pressures may be easing. The year-over-year change in core CPI, which excludes food and energy, fell from 4.7% to 4.3% in August. Meanwhile, the frequently cited core services inflation, which excludes goods and shelter, also eased in August, declining from 3.3% in July to 3.1%. Additionally, supercore inflation, which excludes food, shelter, and energy, rose by 2.2% in the same period but was modestly above its 20-year historical average of 1.9%. Therefore, there is still a case for the Fed to stand pat, at least for now.

  • The latest CPI report is unlikely to have a significant impact on the FOMC’s decision of whether to keep interest rates unchanged during its next meeting on September 19-20. Although policymakers have not commented on how they would vote in the meeting, members have expressed concern regarding the level of tightness in the labor market. The committee is 25 bps shy of meeting its fed funds target outline in the latest dot plots. As a result, we will be paying close attention to the latest FOMC projection materials and Fed speeches for evidence of the committee’s thinking on future rate hikes.

Policy Pushback: Economic woes are prompting policymakers to reconsider rate hikes amid slowing output and lawmaker complaints.

  • The European Central Bank (ECB) raised its benchmark policy rates by 25 bps on Thursday. The increase comes amidst signs that inflation is starting to return to normal but still remains well above the central bank’s 2% mandate. Despite the decision to tighten monetary policy, markets believe that the central bank is likely finished hiking rates. During the press conference, ECB president Christine Lagarde suggested that rates are currently in sufficiently restrictive territory but stopped short of ruling out an additional hike. As a result, the euro (EUR) fell against the USD and Japanese yen (JPY).
  • Unlike the United States, the eurozone economy is more fragile, partly due to its greater reliance on exports, which are being hurt by China’s economic slowdown. European Central Bank officials downgraded their growth expectations for the next three years and hinted at the possibility of recession. At the same time, high interest rates have hurt manufacturing activity throughout the bloc, with industrial production falling 2.2% from the prior year in August. These troubles are not likely to go away anytime soon as the ECB projects that rates will likely stay above 3% in 2024, making it harder for them to justify rate cuts.

Return of the Industrial State? Governments are becoming more assertive in protecting domestic industries as the world begins to fracture into blocs.

(Source: Wikimedia Commons)

  • Governments in advanced economies are likely to play a more active role in the economy than investors are used to, reflecting a long-term trend of supporting domestic firms to compete with foreign competitors. This is already evident in the Inflation Reduction Act, which uses tax subsidies to build domestic manufacturing in the U.S., and in similar incentives offered by the EU. While this shift may help businesses subsidize their research efforts, it could also lead to higher inflation and borrowing costs due to inefficiencies associated with firms being unable to use outside suppliers.

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