Has the market overreacted to the US CPI data for March?
Financial markets have a peculiar approach: investors are “shocked” when economic data doesn't match predictions, even when few people initially believe these predictions. This was the case with last week's US inflation data.
According to previous data, the US CPI increased 3.5% year on year in March, higher than the expected 3.4%; core CPI increased 0.4% month-on-month in March, higher than the expected 0.3%. Exceeding expectations by 0.1% triggered a frantic repricing of expectations for the 2024 Federal Reserve interest rate cut.
Admittedly, investors think it is entirely reasonable for the Federal Reserve to change its position on cutting interest rates three times in 2024. However, adjusting interest rate expectations based on inflation predictions that have been arrived at with little confidence — from 3 interest rate cuts to 1 or no interest rate cuts — seems problematic, and in-depth segmented data also supports this view.
Housing in segmented projects has always been the focus of the market. However, according to CPI statistics, housing is actually driven by “equivalent rent for residential homeowners” (OER). This is the Bureau of Labor Statistics's estimate of the rent self-occupied homeowners would have to pay if they rent their home. It weighs up to 34% of the core CPI (excluding food and energy).
But the OER calculation itself is questionable: first, it is based on rent estimates for similar rental housing. Second, including the EU HICP and UK CPI indicators used by the European Central Bank and the Bank of England — none of them.
As for the PCE inflation index favored by the Federal Reserve, OER's share is much lower: the core PCE only gives it 13% of the weight, and less emphasis on OER gives PCE a more accurate picture of inflation.
Paul Donovan, chief economist at UBS Global Wealth Management, commented:
Precisely because OER is completely fictional, the real cost of living for homeowners is milder than the CPI suggests.
Currently, the Federal Reserve seems to have fallen into a trap: after increasing the importance of CPI as an indicator of inflation, discussions on cutting interest rates have now become very difficult. However, if we look at PCE indicators, the situation is much more optimistic: inflationary pressure on housing, labor, etc. is easing, which means that core PCE should also be further mitigated.
Given the limits on real interest rates, the weak economy, and the potential for inflation, the Federal Reserve may still need to cut interest rates. However, given Powell's comments this week, the Federal Reserve is more likely to cut interest rates later this year, and will also reduce the extent of interest rate cuts.
Editor/Jeffrey