What is the risk of second inflation?

The market is more sensitive to Fed’s rate cut estimate. Whether a second wave of inflation in the US is moderate, has become a new topic of analysis.

The next one to two pieces of inflation data are crucial in determining the pace of rate cuts for the year, as current rate cuts are not a response to economic deterioration

Inflation Outlook

Core CPI is expected to remain elevated around 3.5% in Q3 2024, before a slight uptick to 3.6% by year-end due to base effects.

Leading indicators like rents and wage growth are showing signs of moderation, which should help cool inflation in the coming months.

Financial Conditions

Tightener financial conditions, driven by higher interest rates and tightening credit spreads, are suppressing demand and inflationary pressures.

However, there is a risk of a feedback loop if markets overprice rate cuts, leading to easier financial conditions and reigniting demand.

Supply-Side Shocks

Geopolitical tensions or policy-induced supply constraints (e.g., tariffs) ahead of the 2024 US elections could trigger supply-side inflationary pressures.

Such as geopolitical tensions and policy supply constraints related to the U.S. elections.

Additionally, the reflexivity of financial conditions, where significant interest rate declines could reignite housing market activity and lead to a wealth effect from rising stock prices, potentially delaying rate cuts and creating a dilemma where expectations of rate cuts prevent them from happening.

Market Dynamics

A premature rally in equities and commodities, driven by overly optimistic rate cut expectations, could reignite inflationary pressures through wealth effects and higher input costs.

The window for policy adjustment is narrowing, with Q3 2024 being a crucial period before the election cycle intensifies.

In Summary

The risk of significant secondary inflation, apart from a slight year-end rebound, is not high. High interest rates are deemed sufficient to suppress demand. However, the risk arises from premature expectations of successful inflation resistance, mirroring the situation since the beginning of the year.

While the baseline scenario suggests a gradual cooling of inflation, risks remain skewed towards a potential second wave, particularly if financial conditions ease prematurely or supply-side shocks materialize.

Vigilance is warranted, as the Fed navigates a narrow path to achieve its inflation target.