US Inflation Softens, Calming Investors’ Nerves

What just happened?

US inflation continued to cool in April, according to the consumer price index (CPI), notching its tenth-consecutive decline and falling slightly further than market watchers were expecting.

The all-items or “headline” CPI rate dipped to 4.9% on an annual basis, falling below 5% for the first time in two years, and the “core” CPI measure – which strips out more volatile energy and food prices – cooled to 5.5% (top half of the chart). On a month-to-month basis, both core and headline measures rose 0.4% (lower half), indicating that prices are still rising, but at a slower pace.

But there’s a fair amount of good news in the report: “supercore” inflation – the Fed’s favorite measure as it tracks core services but excludes shelter prices, and therefore is a better representation of labor tightness – also slowed to 5.1% from 5.8%.

So what does it mean?

It suggests that investors can cheer up: with inflation now convincingly in retreat, the Federal Reserve (the Fed) can probably stop hiking rates for now. If inflation had remained flat in April (or had even ticked higher), investors would have had to rethink their expectations that there’ll be rate cuts later this year, and that would have sent both bond and stock markets much lower. This did not happen.

But it’s not all sunshine and rainbows either: inflation’s still too uncomfortably high for the Fed to truly pivot and start to cut rates, and it’ll likely take more economic pain for inflation to fall more decisively toward the Fed’s long-term 2% target. Sure, headline CPI fell from a peak of 9.1% in June to just 4.9% in April, but the core inflation gauge, at 5.5%, is still stubbornly close to its September peak of 6.6%. With the fall in oil prices and the comeback of supply chains now reflected in the measure, it’s already scored its easy wins: a further reduction will be more difficult to achieve.

What’s more, this inflation report shows a lot of components still rising, suggesting it’ll take a more significant slowdown in wage growth for goods and services inflation to fall back to more normal levels. In fact, a simple look at the month-over-month price gains over the last few months shows that inflation’s not exactly showing encouraging signs of abating.

So you can expect a pause in rate hikes, but don’t expect a Fed rate cut unless the economy slows down more significantly. That rate-cut and downturn combo is something that bond investors are expecting (along with yours truly), but the feeling’s not shared among stock investors.

As long as inflation has been falling faster than growth has been falling, it’s understandable that the market reacts positively. But it’s when growth will fall faster than inflation that things might get dicey. And sure, today’s release means that the ideal “soft-landing” scenario – where those rate hikes cool the economy just enough to bring inflation back to target without triggering a recession – is a bit more likely, but I still wouldn’t bet the bank on it. In this environment, you know the drill: hold some gold, some Treasury bonds, and some cash to make your portfolio a bit more robust just in case things don’t go as planned.