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(Kitco News) Markets are recalibrating after the latest inflation report, with the most likely outcome being another rate hike in May and a possible rate cut in July.
Inflation data from March showed the consumer price index (CPI) up 0.1% on a monthly basis after advancing 0.4% in February. On an annual basis, the CPI was at 5% — the smallest gain since May 2021. Housing costs were the main inflationary driver last month.
Meanwhile, Federal Reserve Chair Jerome Powell's favorite inflation measure — core services excluding housing — climbed 0.4% after February's 0.5% increase.
"This inflation report had a lot of mixed signals. The food index at home was lower for the first time since September 2020. The energy index plunged 3.6% in March," said OANDA senior market analyst Edward Moya. "Housing costs edged lower but are still high and contributing the most to inflation (70% to the net monthly change in the headline CPI)."
Many economists agree that the Fed will likely proceed with another 25-basis-point rate increase in May.
"With core non-shelter services inflation still not showing any significant easing and core goods prices rebounding, the Fed is more likely to push ahead with a final 25bp interest rate hike at its next policy meeting," said Capital Economics chief North America economist Paul Ashworth.
After the inflation report was released Wednesday, Richmond Fed President Thomas Barkin noted that more work was needed to stabilize the core inflation.
"I put particular focus on the core, which is still running a little over 5% year over year. And you know, we had some good news on energy, but there's still more to do, I think to get core inflation back down to where we'd like it to be," Barkin told CNBC.
However, there is some divergence within the Fed's ranks. On Tuesday, New York Fed President John Williams said that more rate hikes are needed to bring inflation down. "We need to do what we need to do in order to make sure we bring inflation down," Williams said in an interview with Yahoo! Finance.
Meanwhile, Chicago Fed President Austan Goolsbee voiced support for "prudence and patience." Goolsbee urged officials to be cautious at an event hosted by the Economic Club of Chicago. "We should gather further data and be careful about raising rates too aggressively until we see how much work the headwinds are doing for us in getting down inflation," he said.
Comerica Bank chief economist Bill Adams said the rate hike in May is very likely the last one in this tightening cycle. "The Fed's dot plot anticipates keeping the Fed funds target at that level through the end of this year, but there is a good chance that a slowing economy will push them to cut before then," Adams said Wednesday.
But even though May's increase to a range of 5.00%-5.25% may mark the peak in tightening, higher rates increase the chance of a "hard landing," said ING chief international economist James Knightley.
"The Fed's dual mandate of price stability and maximizing employment gives them greater flexibility than most other central banks. Assuming we are correct that inflation slows rapidly through the second half of the year and the unemployment rate starts to rise, we see the potential for the Fed to cut rates by 100bp before the end of the year," Knightley pointed out.
FOMC minutes from the March meeting revealed several officials considered pausing due to the turmoil in the banking sector. "Several participants ... considered whether it would be appropriate to hold the target range steady at the meeting," according to the March meeting minutes that were released on Wednesday. "Many participants noted that the likely effects of recent banking-sector developments on economic activity and inflation had led them to lower their assessments of the federal funds rate target range that would be sufficiently restrictive."
Implications for the gold market
For the gold market, inflation is not slowing down fast enough to warrant a run-up to record highs, said Moya.
"This inflation report is promising for disinflation trends, but it doesn't mean the Fed's tightening work is done," he said Wednesday.
At the time of writing, June Comex gold futures were trading at $2,029.80, up 0.53% on the day.
Gold's overall bullish trend is still intact, but prices are likely to remain in consolidation mode until there is some clarity around economic growth and the Fed's action plan for this spring and summer, Moya added.
If the market concludes that rate cuts will follow the hike in May, gold will rally higher, according to TD Securities commodity strategist Ryan McKay. "It could be the catalyst needed to see gold challenge the highs yet again. With that said, CTAs could add fuel to the fire with the next upside trigger sitting at $2064/oz," he noted.
The big caveat for gold is the Fed being more hawkish than expected, which would push prices lower.
Commerzbank is pricing in another 50 basis points worth of rate increases and no rate cuts this year. "This would mean a further rise in interest rate expectations and thus another downward correction for the gold price," said Commerzbank analyst Thu Lan Nguyen. "We expect the gold price to drop to roughly $1,900 per troy ounce by mid-year."
Gold could lose the $2,000 an ounce level if the Fed fails to communicate a clear pivot, Metals Focus managing director Philip Newman told Kitco News.
"We are skeptical that gold holds at this level for some time. The Fed hasn't said it was ready to start cutting rates. Right now, we've got a disparity between what the market is expecting and what the Fed is actually saying," Newman said. "Going into the second half of the year, the market will move more towards the Fed's position."
Once the selloff kicks off, gold's price floor could end up being down at $1,700s. But if gold can hold above $1,900 for longer, it could limit the selling, Newman added. "That may mean that the gold price falls less. But we still think the price will weaken considerably," he said. "Could you see it falling into the $1,700s? That is possible."
