A pocket of the market sees inflation drifting close to Fed's goal by June - but BofA says don't count on that

oil
Andrey Rudakov/Bloomberg
  • A corner of the market is pricing in US headline inflation falling to 2.25% by June.

  • But the CPI fixings market is seeing inflation falling too quickly, says Bank of America.

  • BofA sees a pick-up in oil prices putting upward pressure on inflation readings.

A small but historically accurate portion of the financial market is pricing in the possibility of US headline inflation slowing down to just above the Federal Reserve's 2% target by this summer  – but that's a tall and improbable order, Bank of America said Monday.

The so-called CPI fixings market reflects expectations for the Consumer Price Index to reach year-over-year growth of 2.25% by June, the investment bank said in a note published Monday. But the economics team at BofA expects the headline CPI rate to remain above 2.25% until the second half of 2024.

"We think that the inflation market has gone too far," Meghan Swiber, director of US rates strategy, said in the note. She said the market-implied inflation trajectory is possible but unlikely.

Hedge funds and other professional investors trade in the CPI fixings market, with instruments related to inflation-protected Treasury bonds. The market has been considered largely accurate in its inflation projections.

The year-over-year CPI rate has been easing since hitting a high of 9.1% in June, and most recently was at 6.5% in December.

BofA said on an annualized pace over the last six months, CPI has averaged around 2.1%. "However, much of the moderation has come from energy which we do not expect to persist," said Swiber.

The commodity team at BofA projects West Texas Intermediate crude will climb to $99 a barrel by June, or roughly a 20% increase from Monday's price of $81.60 a barrel.

"The market scenario is difficult to engineer given our expectations for non-core components to average 0.4% over the next 6 months," the strategist said.

One scenario that could justify market pricing would be an economic downturn arriving earlier and more sharply than anticipated. BofA projects a recession to begin in the second quarter. Housing and manufacturing data suggest those sectors are already in a recession and layoff announcements have been picking up pace, Swiber said.

"Under this scenario, inflation would be dragged down by both fading transitory effects and falling demand. Therefore, we would expect to see an acceleration in core goods deflation coincide with core services disinflation," she wrote.

While there are paths to headline inflation driving down to 2.25% by June, the likelihood of inflation falling that quickly is low. It will take time to rebalance the labor market and to see sustainable moderation in wage growth, the strategist said.

"That said, if inflation were to fall that quickly, then it would likely mean the Fed would begin cutting rates earlier than we currently anticipate, specifically if the labor market cools enough for the Fed to have confidence that core services will not accelerate."

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