First the debt ceiling, then inflation

President Joe Biden delivers remarks on an agreement reached yesterday with House Speaker Kevin McCarthy to raise the national debt ceiling in the Roosevelt Room of the White House on May 28, 2023 in Washington, DC.

Anna Rose Layden | Getty Images News | Getty Images

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A deal to raise the US debt ceiling has finally been reached. But investors still have to deal with persistent inflation and higher interest rates.

  • US inflation in April was stubbornly high and the economy still strong. The personal consumption expenditure index rose 4.4% from a year ago, up from 4.2% in March. Spending also jumped 0.8% in April, twice as much as expected, while personal income rose an expected 0.4%.
  • U.S. stocks rallied on Friday, with all indexes closing above 1% as investors hoped for a debt ceiling deal (looking back, it seems their hopes weren’t misplaced) . European markets also traded higher. The Stoxx 600 index rose 1.2%, driven by technology stocks which jumped 3%.
  • PRO Japanese stocks are proving irresistible to investors this year, especially after Warren Buffett publicly endorsed the country’s market in April. Some fear the current rally will be reminiscent of the 1990s bubble – but there are signs it could have “lingering power”.

A deal to raise the US debt ceiling has finally been reached. Take a deep breath, but don’t completely relax just yet.

The deal still has to pass a vote in Congress, where it could be the subject of further wrangling on both sides of the partisan divide. Plus, the deal includes spending cuts, which is exactly what the United States doesn’t need if it does indeed slide into a recession that many economists have warned about (although that recession is the expected in economic history still looks six months away).

Still, the fact that Biden and McCarthy have reached a preliminary deal should give investors the confidence to put aside US default fears and focus on markets and the broader economy.

But it’s not business as usual there – hence my advice not to relax yet. The US economy this year still managed to surprise even after a tumultuous 2022 that upended everyone’s assumptions.

Inflation is still uncomfortably high. In fact, according to the PCE report, consumers spent more on goods and services in April than in March. This suggests that inflation is not high and subdued – as indicated by the consumer price index, another reading of inflation – but is high and rising. Indeed, the PCE report showed spending jumped 0.8%.

As the PCE is the Federal Reserve’s favorite inflation indicator, we shouldn’t ignore the warning signs of lingering inflation – and potentially rising interest rates – as the index flashes. Indeed, markets are now betting that the Fed will hike rates instead of pausing at its next June meeting. According to data from the CME Group, there is now a 56% chance of increasing by a quarter of a percentage point. The probability was only 17% two weeks ago.

In other words, the debt ceiling smash may soon be over, but that means we are returning to a world of persistent inflation, high interest rates and an ever-looming recession. Not really a welcome return to normal.

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