FOMC Preview: Yes, There Was Some Good News in Friday’s CPI

Markets are throwing a tantrum ahead of Wednesday’s FOMC. Based on last Friday’s worse-than-expected May CPI report, expectations have built in another two rate hikes and some probability of a 75 bp hike on Friday, implying a policy path more aggressive than mere normalization. But core CPI on a year-on-year basis decelerated for the second month in a row, perfectly corresponding to the similar deceleration in M2 growth after its peak in February 2021 (the two are highly correlated with a 13-month lag). As the further already-accomplished deceleration of M2 growth feeds into inflation with a 13-month lag, core CPI will continue to decelerate. All the Fed has to do is wait, because the cessation early last year of massive pandemic spending programs is already a sufficient policy response to lower inflation. Based on the regression equation linking M2 and inflation, core CPI will be 2.49% year-over-year in May 2023. Following his long-delayed confirmation for a second term, Powell will likely want to look for this good news among the bad news in Friday’s report, all the more so with markets begging him to remember he wields The Fed Put. We do not expect a 75 bp hike on Friday, and we look for surprisingly comforting words from Powell. Markets will be relieved.