One soft inflation report: signal or noise?

The April consumer price index, published on 15 May, showed inflation at 3.4 per cent year-on-year, with core prices rising 0.3 per cent on the month, the first slowdown in four months. Bond markets were relieved. Ten-year yields fell sharply and traders put rate cuts back into the forward curve.

Three hot months first

The relief makes sense only against what came before it. Core prices rose 0.4 per cent in each of January, February and March, a run that turned a comfortable disinflation story into an awkward one. At the turn of the year futures had priced as many as six quarter-point cuts for 2024; by April they priced one or two. The Federal Reserve, which has held its policy rate at 5.25-5.5 per cent since July 2023, stood pat again at its meeting at the start of May, and its statement conceded a lack of further progress towards the 2 per cent target in recent months.

One swallow, no summer

Bond investors should hold off on the celebrations. A single month of modest slowing does not make a trend, especially with shelter costs still high and base effects turning unfavourable in the second half of the year. The Federal Reserve will want several months of similar readings before it endorses the market's hopes for easing.

The base effects are simple arithmetic. The monthly readings from the second half of 2023 that will drop out of the annual comparison were mostly modest, so a string of 0.3 per cent prints would leave the twelve-month rate roughly where it is rather than pulling it lower. Core inflation over twelve months eased to 3.6 per cent in April. Holding at that level through the autumn would not look like victory to anyone on the committee.

Why one month says little

Monthly core inflation is a noisy series. It is reported to one decimal place, so the gap between a 0.3 and a 0.4 can come down to a few hundredths of a point, well within the ordinary wobble from seasonal adjustment, used-car prices and motor insurance, which has been rising at a double-digit annual pace. Even taken at face value, 0.3 per cent a month compounds to an annual pace of about 3.7 per cent. Reaching the Fed's target requires monthly readings nearer 0.17 per cent, and April was not close to that.

A statistician would put it more formally. When a series is this noisy, one new observation shifts the estimate of the underlying trend only slightly, because it has to be weighed against the months that came before it. Including April, the three-month annualized rate of core inflation is still above 4 per cent, and the six-month rate is not much lower. Those smoothed measures, which the Fed's staff track closely, barely moved on the news.

The composition of inflation also argues for caution. Goods prices have been flat or falling as supply chains recovered from the pandemic, so services now account for nearly all of core inflation. Services prices depend heavily on wages, and wage growth is cooling only slowly, which means the component that matters most is also the one least likely to deliver a sudden run of soft months.

False dawns before

Markets have celebrated too early before. In 2022 a soft July report sparked a rally in stocks and bonds, and the hot August figures, released in mid-September, ended it abruptly; the S&P 500 had its worst day since June 2020. Late 2023 offered a gentler version, when benign readings persuaded traders that cuts were imminent and the first quarter of this year took most of them away. The pattern in both cases was a curve that repriced faster than the underlying trend changed.

The stakes of the repricing are not confined to bond desks. Thirty-year mortgage rates, which track the ten-year yield, have hovered around 7 per cent, freezing housing turnover and keeping homeowners with cheap fixed-rate loans in place. Every swing in cut expectations passes quickly into those rates, and into the valuations of rate-sensitive shares such as housebuilders, utilities and small caps that carry floating-rate debt.

What the Fed needs to see

Powell set out the committee's position at his press conference on 1 May. He said a rate increase was unlikely to be the next move, which took the most hawkish scenario off the table, but he also made clear that the Fed would need greater confidence that inflation was moving sustainably towards 2 per cent before easing. That is a test of accumulated evidence, and one month of 0.3 per cent does not pass it.

The Fed's preferred gauge adds a wrinkle. The personal consumption expenditures index gives much less weight to shelter than the CPI does, so the two measures can diverge. Core PCE inflation stood at 2.8 per cent over the twelve months to March, closer to target than the CPI suggests. If the April PCE reading comes in soft as well, the argument for a cut before the end of the year gains weight; if it does not, the CPI relief will look even thinner.

What would change the call

The optimists have a real argument. Rents on new leases slowed markedly through 2023, and because the official shelter measure tracks existing leases with a long lag, that slowdown should keep feeding through for months. If shelter cools while goods prices stay flat, May and June could look much like April, and three soft readings in a row would give the Fed the run it wants. The April index for personal consumption expenditures, the Fed's preferred gauge, is due at the end of the month, and the May CPI arrives just as officials meet in June to publish fresh projections.

The same day's data offered one more clue. Retail sales were flat in April, a sign that consumers may finally be tiring, and a softer spending picture would make the next few inflation reports easier to believe. Stock indices set record highs on the combination. That enthusiasm assumes the soft patch in both prices and spending lasts, which is a larger bet than a single month's data can support.

Bondholders can enjoy the rally, but the Fed will not cut on the strength of one good month. It needs a run of soft readings, and if the next couple of reports run hot, the cuts will come out of the curve as quickly as they went in. September is the earliest meeting at which the committee could plausibly have the evidence it wants.