U.S. July inflation may worsen Fed's future dilemma 
Jimmy Zhu

Editor's note: Jimmy Zhu is chief strategist at Fullerton Research. The article reflects the author's opinion and not necessarily the views of CGTN.

More investors expect the Federal Reserve (Fed) to slow down rate hikes after the U.S. consumer price index (CPI) grew less than expected in July from a year ago. However, the current financial market reaction may put the Fed in a difficult position.

The U.S. CPI grew 8.5 percent from a year ago in July, down significantly from 9.1 percent in June. Core CPI, which excludes energy and food prices, slowed to 0.3 percent on a month-on-month basis.

The Dow Jones index gained over 500 points, and the Nasdaq composite index jumped almost 3 percent on Wednesday, while the dollar and U.S. Treasury yield tumbled. Most market participants expect the Fed to increase policy rates by 50 basis points (bps) next month, not 75 bps.

A few days before the CPI release, a resilient jobs report showed the country added 528,000 jobs in July, which convinced many traders that the Fed would raise rates by another 75 bps for a third time in September.

Will the market change its expectations for Fed policy again if the U.S. releases another strong job report in early September?

It's very likely. Flip-flopping has become increasingly common among the Fed and market participants. In the past few months, the Fed has made decisions based on a single piece of data, and it may continue to do so in the coming months.

In early June, a jump in May CPI data prompted the Fed to raise rates by 75 bps for the first time since 1994. Just a few days before the Fed meeting in June, there was increasing speculation in the markets that the Fed would hike the rates by 75 bps instead of 50 bps, and the Fed did so.

Little policy consistency indicates trouble ahead

What drove the July CPI slowdown is critical to understanding whether inflation easing is sustainable or just a temporary event.

To be clear, the decline in gas prices was the main factor that eased inflation in July, and this trend may not last until the end of the year.

Last month's gas price drop was mainly due to a fall in oil prices. West Texas Intermediate crude dipped below $100 per barrel in July, well below $125 in early March.

A stronger dollar in recent months and "recession trades" have sent riskier assets, including crude oil prices, lower. It is worth noting that the negative correlation between the dollar and crude oil has been at 0.63 for the past 10 years.

Expectations that the Fed will slow the pace of tightening have prompted some traders to sell dollars. A softer dollar will support oil prices if the negative correlation remains high.

Furthermore, the global energy supply remains tight, and many European countries are experiencing energy shortages.

That said, further substantial declines in energy prices toward the end of the year look remote, which means significant decreases in U.S. gas prices may be behind us. If U.S. inflation accelerates in the coming months, Fed Chair Jerome Powell will soon find it difficult to explain the inflation outlook and manage market expectations.

If Powell is still determined to curb inflation towards the central bank's target, he cannot act as dovish as some traders expect. Such a result will lead to another big sell-off in the U.S. financial market. One CPI report cannot reveal much about the future, and he needs to be more consistent in setting his policy outlook. Otherwise, he may lose control of market expectations, increasing the instability of the financial market.  

Back in the days of Ben Bernanke and Janet Yellen, the Fed wouldn't change course based on a single piece of economic data. Consequently, they led rather than followed market expectations.

Search Trends