It’s Groundhog Day.
The CPI reading for September came in this morning. Core CPI smashed expectations at 0.6% month over month, while the headline number of 8.2% was also north of expectations at 8.1%.
Predictably, a bloodbath ensued.
While markets have rallied back since, it still goes to show that the single biggest variable in the markets right now is inflation. The CPI readings have turned into a monthly party, with the number governing the Federal Reserve’s response. It’s just hard to know in advance whether it will be a celebration party, or a funeral party.
The 8.2% reading this afternoon means the September edition is a funeral, with a 75 bps hike in November all but guaranteed, with markets also pricing in a 50 bp hike in December.
There is only one thing running markets right now – something I have been writing about extensively.
This is not a surprise
Nothing is surprising here; this has been the pattern for months. Many warned of the danger of printing an unprecedented amount of money during the COVID pandemic, and we were always going to have to pay the piper.
Inflation is not a surprise – many have been crying about the impending pain for a while now. It is simple maths: create more money and the value of that money falls. Unfortunately, the only way to rein in the inevitable inflation from all the printing is interest rate hikes – and those hikes hurt.
So, as inflation remains more stubborn than the Fed wants, interest rates require hiking more aggressively. With the cost of borrowing higher, investment slows and demand falls. In essence, liquidity is sucked out of the economy.
Additionally, with companies commonly valued by discounting future cash flows to the present, these valuations fall with rising interest rates, as the cashflows are discounted back to the present via higher interest rates.
To look at this another way, if I offer you $10 this time next year and interest rates are 3%, but then before you accept they jump up to 6%, that $10 is now worth less because you are discounting it back to today at 6% rather than 3%.
What does the future hold?
This is really a question about how much inflation heartache has been priced into markets. There has been a lot of pain to date, but if inflation continues to smash expectations, it won’t subside anytime soon.
The Fed has been adamant that inflation is the number one concern. Once the numbers slow perceptibly and the demand levels off, we can start to relax. But the labour market, despite recent weakening, is still stout. There is still a lot of money out there.
Winter is coming, which used to be a fun quote from Game of Thrones, but now has people trembling given the state of the energy crisis. The war is still waging in Ukraine. Despite me saying that inflation is ruling markets, there are other factors which could emerge going forward. My feeling is that we have a long few months ahead of us, and the economy still has a lot of cooling off to do.
Time will tell, but for the moment, the most important gig in town is the CPI reading each month.