The Underestimation of Inflation in the Market

Reuters — Yesterday, the dollar weakened across all fronts. This suggests that the market is either anticipating a decrease in inflation, despite the core forecast remaining unchanged from the previous month, or it is indifferent to whether the core remains at 4.1% or even rises, as long as the headline shows a decline. The headline for September was 3.7%, and the forecast for October is 3.3%, which is a satisfactory result. The decline in oil and gasoline prices is largely responsible for this.

This conclusion is alarming as it indicates a lack of grounding in reality. The Federal Reserve (Fed) does not focus on the headline; it concentrates on the core. Moreover, it doesn’t primarily consider the Consumer Price Index (CPI); it prefers the Personal Consumption Expenditures (PCE) price index.

UBS Surprising Prediction

Interestingly, UBS predicts that the Fed will slash rates by a staggering 275 basis points next year, which is about four times what others are forecasting. The UBS analyst stated to Bloomberg, “We don’t see the conditions for why this time is so different. Inflation is normalizing quickly and by the time we get to March, the Fed will be looking at real rates which are very high.”

The strategists anticipate the benchmark federal funds rate to drop to between 2.5% and 2.75% by the end of 2024, and they predict the terminal rate to be 1.25% by early 2025. This prediction is based on their expectation that the US economy will enter a recession by the second quarter. In contrast, money markets are pricing the Fed to cut by just 75 basis points, starting by July.

The Market’s Misjudgment of Inflation

The market continues to underestimate inflation, leading to an overestimation of the speed and extent to which the Fed could begin reducing rates. This doesn’t mean that we won’t see a wave of frantic dollar selling if today’s data meets expectations—even if those expectations wouldn’t impress the Fed at all.

In conclusion, understanding the market’s perception of inflation and its potential impact on the economy is crucial. While some predictions suggest a downturn, it’s important to remember that these are just forecasts and the actual outcome may vary. The economy is a complex system influenced by numerous factors, and inflation is just one piece of the puzzle.