The US Consumer Price Index (CPI) dropped to 4.0% in May, down from 4.9% in April and just below the consensus of 4.1%. This was the lowest level since March 2021. Core CPI fell from 5.5% to 5.3%, in-line with expectations.
The drop in inflation demonstrates that the Federal Reserve’s rate hikes are filtering through the economy and having their desired effect of lowering inflation. That is certainly good news, but the sharp decline in headline inflation was primarily due to a drop in food and energy prices. Core CPI, which excludes food and energy, remains stubbornly high, and unless it falls more quickly, the Fed will have a tough time wrestling inflation back down to the Fed’s 2% target and that could mean more rate hikes in the second half of the year.
US inflation reports have gained in significance ever since the Federal Reserve circled inflation as public enemy number one. Tuesday’s inflation release has added importance since the Federal Reserve is meeting today. Fed Chair Jerome Powell has signaled that the Fed plans to take a pause after 11 straight rate increases. However, some Fed members are more hawkish and have said they favor more rate hikes.
The market pricing of interest rate moves has fluctuated sharply in recent weeks and the probability of a pause has jumped close to 100% in the aftermath of Tuesday’s inflation report, which means a rate hike would be nothing short of a huge shock.
As mentioned, the Fed is split on whether to pause or continue increasing rates. This could force Powell to choose the middle ground, in which the Fed pauses or “skips” a rate hike but stresses that this is not the end of the rate-tightening cycle, and the door remains open to further hikes in the coming months. The rate statement and Powell’s press conference after the rate decision may provide clues about future rate policy.
In the Forex market, the US dollar retreated on Tuesday against all the major currencies except the Japanese yen. The US dollar recorded light losses against the Australian, New Zealand and Canadian dollars. The British pound climbed almost 1%, boosted by a sizzling UK jobs report, putting the GBP/USD currency pair in focus.
On Wednesday, the US dollar is steady in the European session. There is a strong possibility of volatility in the North American session when the Fed makes its rate announcement.
US stocks climbed higher on Tuesday on investor optimism that the Fed would cut rates at the Wednesday meeting. The S&P 500 Index rose by 0.69% to close at 4,369 and the Nasdaq 100 Index climbed 0.83% to close at 13,573.
On Wednesday, stock market futures edged higher. S&P futures are up 0.17% and Nasdaq futures are up 0.24%.