The Federal Reserve recently hiked interest rate by another 0.75% in July. As stated in our previous communication, "The Fed Continues To Focus On Inflation," this hike did not come as a surprise. The market had been pricing in a 75 basis point increase for July. The Fed’s is trying to control inflation by keeping long-term expectations anchored.
For the past year, supply-related problems contributed more to inflation than demand-related imbalances, however that may be changing soon. There are at least three factors that could change the course of inflation.
First Factor: Improvements In Global Supply Chains May Be A Bright Spot
Inflation dynamics may be at a crossroad. Since the onset of the global pandemic, the inflationary environment has been aggravated by supply-related problems with ports, international manufacturing shutdowns and global shipping as primary challenges. For example, auto manufacturers are still hampered with ready access to necessary components.
The good news is that as of the last inflation report, the supply contribution to inflation fell and demand-driven contributions to inflation became more of a dominant factor. This scenario fits perfectly into the script for the Fed. Their monetary policy tools are intended for tamping down aggregate demand. The Fed's policy works on a lag, meaning that a Fed decision takes time to filter through the system.
Second Factor: Strong Dollar Affecting Purchasing Power
A strong U.S. dollar could help ease some of the pressure off of the high prices we have right now. Of course, we know that a sustained strong dollar will eventually give us some greater purchasing power in the global markets and will pull down import prices. The year 2022 started out with import prices rising very quickly on a monthly basis. In just the 31 days of January, import prices rose 2% and then import prices rose another 2% month over month in February and roughly 3% in March. These import prices were running hotter than the CPI over that same time period. However, as the dollar has rallied in recent months, import prices have begun to cool. For example, June import prices rose a mere 0.2%, the smallest increase in six months.
Third Factor: Lower Import Prices are Net Positive for Taming Inflation
Lower import prices will take some time to filter through to the end consumer. Recent trends in the U.S. dollar could keep import prices at bay and by transmission, tamp down some of the import-sensitive consumer prices. A slowdown in import prices, partially attributed to a strong U.S. dollar, is an important variable we think could ease these high levels of consumer inflation [Figure 3].
Conclusion: What Does This Tell Us About Fed Policy?
LPL Research's base case for the federal funds target rate at the end of this year is 3.50% with potential for the terminal rate to eventually reach 3.75%. However, the nagging persistence of some consumer prices or the rising risk of a contracting economy might change the plans for the Fed. The Fed is widely expected to slow rate hikes to increments of only 50 or 25 basis points going forward. Investors and policymakers know inflation will likely stay above target for some time.
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The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
All index data from FactSet and MarketWatch.
This Research material was prepared by LPL Financial, LLC.