US Inflation Hits Two-Year Low

What You Missed

The Federal Reserve will view recent decreases in the Consumer Price Inflation (CPI) and Producer Price Inflation (PPI) indexes as a welcome development. In June the CPI rose 3% relative to a year earlier, down from the 4% annual rate measured in May, and dramatically down from the 9.1% rate in June 2022, making last month the smallest 12 month increase since March 2021 when inflation began to surge. The June PPI saw an increase of 0.1%, lower than the expected increase of 0.2%.

The Fight Is Not Over

While the fight against price pressures is far from over for both consumers and businesses alike, there may be additional good news on the horizon. As we’ve been saying for weeks now, the upcoming interest rate hike by The Federal Reserve could mark its final move in this regard – potentially raising the benchmark US rate to 5.5% come July 26th and most importantly, staying there. Thus, as has been the case after many recent meetings, Fed Chair Powell’s post meeting statements may carry more weight than the headline rate decision on near-term market movements.

However, the path forward is not completely clear and requires careful consideration by monetary policymakers. The Federal Reserve will carefully weigh numerous factors when deciding how to respond to the inflation slowdown. These include assessing whether it is sustainable or not and evaluating economic growth trends alongside potential risks that may arise in future periods. To gain insight into these areas policymakers will monitor indicators such as wage growth patterns along with supply chain dynamics while also considering fiscal policies’ impact on demand levels.

And don’t forget that Fed Chairman Powell’s success at communicating effectively with the public and financial markets is crucial for managing expectations that maintain stability. Careful consideration must be taken when shifting monetary tightening policies so as not to cause unnecessary market volatility or disruption during transitions. The central bank recognizes this importance and takes great care to speak clearly and concisely.

The inflation debate has been a hot topic for the past two years, dominating headlines and permeating every aspect of US Presidential politics as well as kitchen table conversations. The recent development marks an important milestone in this ongoing discussion.

The Road So Far – How Did the World Get Here?

Of course, inflation hasn’t been just a US challenge. Despite the world economy facing unpredictable circumstances and hurdles stemming from the impact of COVID 19 and Russia’s invasion of Ukraine, nations have shown remarkable resilience. Encouraging signs of progress are emerging as policymakers prioritize sustainability in their efforts to drive growth forward globally. The recovery may not be uniform across regions, but it remains promising nonetheless thanks to these concerted efforts.

The pandemic caused significant damage to emerging economies but now they are showing signs of recovery thanks in part to rising commodity prices and increasing export demand. Countries that implemented effective structural reforms have seen improvements within their business climates while fostering innovation which has led them towards attracting foreign direct investment (FDI) as well as technological advancements. This positive trajectory bodes well for global trade as it continues its gradual recovery from the shock experienced during peak crisis levels.

While there is cause for cautious optimism regarding the global economic outlook, just as in the US, caution remains necessary due to several risks that could derail progress made thus far. These include potential escalations in geo-political tensions, trade disputes, a credit crisis caused by high interest rates and falling real estate values, and inflationary pressures. Policymakers must remain vigilant and adaptable if they are going to effectively address these challenges. The stakes couldn’t be higher – failure would result in significant harm both domestically and globally.

Observation Corner

Making decisions based on fear can oftentimes make the situation worse.  Rising interest rates and inflationary fears have driven many floating rate borrowers to refinance at fixed rates.  It might seem the prudent thing to do, but the decision to choose to refinance into a fixed rate loan may have future negative consequences.  Term fixed rate loans appear attractive because of the inverted yield curve, with long term rates below 1M Term SOFR.  Why the inversion?  The market expects the Fed to begin easing in 2024.

During times of market uncertainty, flexibility is key to successfully riding out the turbulence.  What is the advantage of locking-in at a fixed rate?  The only valid reason is to fix the monthly payment and not worry about short-term interest rates moving higher.  Fixing the rate might be the best solution to mitigate risk, but before committing to that decision consider the possible costly consequences.

Most fixed rate loan terms include pre-payment penalties and some can be quite onerous, particularly when the credit spread is added on top of the cost to refinance, even when there are more favorable credit conditions.  The ability to refinance may not be economically feasible if the cost to pre-pay is too high.

The risk is lost opportunity and how it impacts your finances as a borrower.

Borrowers are waiting for interest rates to fall, credit spreads to contract and inflation to cool. What happens when the market eventually stabilizes?  Inflation is lower, credit spreads contract, and interest rates fall.  Borrowers who value flexibility over certainty will have an opportunity to restructure debt in a more favorable environment.  Those who fixed their rate to gain certainty now must deal with the negative consequences of pre-payment penalties.

Of course, flexibility isn’t free.  However, there are several ways to mitigate interest rate risk and maintain flexibility to take advantage of restructuring opportunities.  For instance, a borrower can fix a rate by purchasing a deep in-the-money (“ITM”) interest rate cap.  The intrinsic value of a cap is set at a strike rate which provides the same economic stream of payments as a fixed rate loan.  The cost of the cap can be considered pre-paid interest.  If rates rise more than expected the cap payments increase, offsetting the higher mortgage payment.  If rates fall, cap payments are lower and so is the mortgage payment. And your lender might be amenable to financing the cost of the cap.

Call us to discuss all the ways to mitigate risk without sacrificing flexibility.  Borrowers should seek an advisory firm that provides an objective view, that has capital market experts who provide guidance based upon analysis and not emotions.  Derivative Logic is that firm.

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