May’s CPI report boosts odds for three more 50bp Fed hikes

US headline inflation rose in May from 8.3% to 8.6%, outstripping expectations for a flat reading and by doing so, quashed speculation that the US economy had seen peak inflation back in April.

Driving the headline figure higher was a 1% MoM increase, which was largely due to increases in food (+1.2% MoM), energy (+3.9% MoM), new vehicles (+1%) and shelter prices (+0.6%). The upwards surprise in the monthly price gains more than offset the expected negative base effects, which were largely expected to drive headline inflation down over the coming months.

Due to the broad nature of the inflation pressures, the core measure also beat expectations as it printed at 6% YoY, marginally down from last month’s reading of 6.2%.

This is predominantly due to the aforementioned base effects. Given the pace of core inflation remained stable at an elevated 0.6% MoM, instead of moderating to 0.5% as expected, markets largely looked through the slight decline in monthly core inflation, as the continued strong momentum in sequential core inflation will likely keep the Fed firmly in its hiking cycle. Within the CPI baskets specifically, owner equivalent rents rose 0.604% MoM, a fresh multi-decade high, while rent of primary residences rose from 0.55% in April to 0.63%. Put in annualised terms, the price of primary residence in the US rose a whopping 5.2159% YoY, another record-breaking level that is likely to send chills down the spines of some Fed officials.

Monthly change in headline YoY inflation and its components 

Barring any substantial downturn in the labour market in the coming months, today’s CPI report has effectively killed Raphael Bostic’s claim for pausing the Fed’s hiking cycle as early as September. Instead, markets are now pricing in the probability that the Fed will have to conduct a fourth consecutive 50bp hike at September’s meeting.

Should the pace of core inflation increases remain elevated over the coming months, the prospect of the Fed hiking rates to their current estimation of neutral by September is increasingly likely. This is not only being projected in money markets, but also in front-end bond yields which sit just shy of 3% after rallying 10bps at the time of writing. Against the backdrop of a stronger economic growth picture, for now, the prospect of a more aggressive Fed hiking cycle heading into Q4 of this year is propping up the dollar this afternoon, especially against currencies where the central banks are likely to have a much lower near-term terminal rate (GBP, EUR, SEK).

Strong US inflation report sends front-end Treasury yields north to 3%, pressuring EURUSD and GBPUSD

Authors: 

Simon Harvey, Head of FX Analysis

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