Neil Shankar and Kevin Headland discuss the likelihood of any Fed action as CPI cools
Wednesday’s US Consumer Price Inflation (CPI) print lined up with analyst expectations and pointed to a picture of moderating inflation. While still significantly above the US Federal Reserve’s two per cent target, the July CPI data revealed on Wednesday show a small decline to 3.4 per cent. Core inflation, which leaves out energy and food prices, fell to 2.5 per cent from 2.6 per cent the month prior.
Signs of moderating inflation can be taken with some softening in the labour market, included an unexpected month of aggregate job losses in July, as a broader signal of an economy that continues to normalize. Neil Shankar, Vice President of Economic Research at CI Global Asset Management and Kevin Headland, Co-Chief Investment Strategist at Manulife Investments explained what this picture means for the US economy going forward and what the US Federal Reserve might do at its next meeting in September.
“My main takeaway is that the market was wrong to price in rate hikes earlier this summer. The past couple of months of data have revealed that inflation is moderating,” Shankar says. “The labour market is not a source of inflationary pressure, and there’s little evidence of broad-based inflation pressure that would justify a more hawkish Fed. And I think today’s report only kind of reinforces that view.”
Headland highlights that bond markets have responded in line with Shankar’s view, with US Treasury yields moving lower across the curve, especially on the short end. Neither Shankar nor Headland see this moderation as opening the door to a Fed rate cut, but they emphasize that it gives Federal Reserve Chair Kevin Warsh greater room to hold rates steady.
What’s keeping US inflation elevated?
While bond markets may take this cooldown in inflation as positive news, the fact of elevated CPI remains. CPI had looked to be moving closer to the Fed’s two per cent target before the outbreak of the US-Israeli war with Iran earlier in the year. That conflict’s significant impact on energy supplies and global oil prices accelerated inflation in the US and around the world. While the delta between topline and core CPI implies the ongoing impact of energy prices, Shankar argues that there is not much driving inflation beyond those oil prices. Headland argues otherwise.
“Inflation is no longer just an oil story,” Headland says. “While energy prices remain an important contributor, inflation today reflects the cumulative effects of past supply chain disruptions and the gradual pass-through of higher input costs to end consumers.”
Headland highlights housing and shelter costs as the largest component of US inflation. While that rising cost has moderated, he notes that it is moderating more slowly than most economist predicted.
Headland agrees with Shankar’s assessment of the labour market, noting that it is less of an inflation driver. Both Shankar and Headland highlighted the recent July jobs report with its unexpected job losses as well as downward revisions to prior months’ jobs reports by the Bureau of Labor Statistics. Rather than signs of AI job displacement, however, both Shankar and Headland note that many of these job losses were seasonal in nature and in industries unlikely to see AI displacing workers. Headland also notes the role of the FIFA World Cup, the end of which caused a drop-off in some seasonal work
The massive capital expenditures associated with the AI buildout have also been cited as a driver of inflation. While Shankar identifies this buildout as a near-term risk to inflation, he notes that there hasn’t made its presence felt in the data in a material way. Headland says that we currently lack a clear way to measure AI-related capital expenditures in CPI. He and Shankar highlight certain impacts like rising costs of technological components but note that these should be put in the context of a far larger inflation basket.
Where this leaves US assets
Headland and Shankar broadly agree that a cooldown in inflation offers a stable picture for financial markets. Both agree that the Fed should now stay on hold through the September meeting and that the bar for additional rate hikes will be high. There are still risks to the US economy and US assets out there, but they appear less acute than earlier in the year.
Headland sees few, if any, major areas of risk for US markets and believes the economy will grow at “a steady, albeit unspectacular, pace,” for the next several quarters. Shankar notes that the tariff impact is now no longer weighing on US inflation and economic outlooks as it once did, though it remains a factor. Both believe the picture for US assets should remain positive.
The relative ‘good news’ of this print can still be viewed in a more negative light if investors prefer to focus on the elevated nature of inflation. Shankar notes, however, that a focus on moderating inflation and a normalizing economy will be more instructive, offering advisors a chance to deliver an object lesson in perspective.
“Advisors should use this as an important lesson and remind clients that this is another example of the importance of separating the noise from the signal. If we look back to earlier in the summer, there were fears of higher energy prices, these nascent AI-related price pressures, tariffs, all dominating headlines and creating fears of this renewed Fed tightening cycle, which was front and center. And I think really over the past couple of months, what we’ve seen is, you know, the signal from the data at least has been quite different,” Shankar says. “What matters most is that broader trend and ultimately what the economic data are actually pointing to. Today that trend remains consistent with moderating inflation, an economy that continues to hold up, and a Federal Reserve that can comfortably remain on hold, all of which should support corporate earnings growth and risk assets.”
