All the markets cared about this week was inflation. How high is it? Is the growth rate slowing? What’s it mean for policy? I’ll try and keep this quick!!

This week we had the consumer price inflation (CPI) report, the producer price number, and a report on import prices. All told a similar story, so let’s use the CPI report as the example. The headline year-over-year growth number came in at 8.5% for July, down from 9.1% in June and slightly less than the consensus forecast of 8.7%. If you strip out food and energy, core inflation was up 5.9%.

Equity markets rejoiced!! What? How does that make any sense – it’s not like 8.5% is a good number? Well, the focus was on the month-over-month rate of change – which was 0%. The chart below shows the month-over-month change (black line) and the components.

Obviously, energy was the big swing factor in July, with prices down meaningfully. Broad energy prices were down 4.6% during the month and gasoline was down 7.7%.

Human nature is to extrapolate, and investors chose to extrapolate their hearts away after the CPI report. If July was flat, then August, September, October…might be flat as well. And if that is the case, inflation is whip’d (apparently, the Ford administration actually printed lapel buttons or their ‘WIN’ initiative).

Ooooo, wait a minute. Even if you assume inflation runs flat through the end of the year, the year-over-year rate of change will still be above the Fed’s 2% target by January 2023. (green line below).

But what the markets care about, at least for now, is the trend, not the absolute level. Maybe the Fed doesn’t have to trigger a recession to get inflation lower? Without question they are still talking tough. Fed governor Neel Kashkari spoke this week and said the Fed is “far, far away” from any sort of victory over inflation. Even more bluntly, he noted that even a recession wouldn’t deter the Fed from hiking rates to bring down inflation. “We have to get back to 2%,” he insisted, reiterating his view that rates should be near 4% by year-end and 4.4% by the end of 2023.

But what else is he going to say? The Fed is going to talk a good game until they don’t. What the markets really reacted to was the likely shallower trajectory of future Fed hikes. Last week the odds of a 75bps hike in September were running well over 70%. By this Friday they had fallen to just 44%.

And probably more importantly, there’s a growing consensus the Fed will then revert to 25bps hikes after that. Basically, the market rallied on the prospect of a less aggressive Fed and a rate hike cycle similar to what we’ve seen since the Greenspan years – slow and steady quarter point hikes every six weeks.

Make no mistake, the Fed will still be hiking, but the market was priced for a return of Paul Volker a few weeks ago. Now the market is pricing in an era of Greenspan gradualism. That would look good on a lapel button!!

Charts We Found Interesting

1. The housing market is weakening and inventory levels are up, but broad inventory levels are still pretty low compared to 2017-2019.

2. Second quarter earnings have been pretty good. So far 75% of companies have beat estimates by 4% in aggregate. The S&P 500 earnings for the quarter are at $57.4, up from $55.5 at the start of the quarter.

3.  Value stocks aren’t at new record levels of cheapness vs. growth stocks, but they are getting close.

4. How the Inflation Reduction Act might impact carbon emissions.

5. Speaking of carbon emissions – it will be good to see someone else win the constructors championship this year.

6. The Rhine is running out of water.

7. This is a problem for a lot of reasons, not the least of which is that coal barges can’t navigate their way to power plants. This is bad news for electricity prices.

8. Another consequence of Europe’s drought – A view of the Roman camp Aquis Querquennis, located on the banks of the Limia River in Galicia, Spain. The Roman’s abandoned it in roughly 120 AD. Until recently it was underwater.

Have a good weekend.

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