This post was taken from our April 16th Weekly.

The market is currently pricing in a 65% probability of a 25bp policy rate cut in the US over the next 12 months. However, the Fed may have to throw caution to the wind late this year or early next year as inflationary pressures are building. In particular, we highlight the 25% surge in unleaded gasoline prices since the beginning of the year, with average prices across all auto fuel types up 15% over this period. With core inflation showing a high degree of persistence (holding above 1.8% since February 2017), a run-up in fuel prices will increase pressure on the headline reading. This tallies with the message from our leading indicators for inflation (bottom-left chart).

This comes at a time when equities are soaring (the YTD rally in the S&P 500 is the largest since 1991), Chinese credit jumped in March (see page 2) and the imminent risk of a no-deal Brexit has been taken off the table. Although global economic uncertainties and structural challenges remain in play, rebounding markets and a renewed uptick in inflation will eventually make it difficult for the Fed to stand on the side-lines. As we wrote in our April monthly report, our base case is the Fed remains on hold this year (barring a recession), but the market is likely to eventually shift back to pricing in some hikes again rather than cuts.

(Click on image to enlarge.)

Source: Bloomberg, Macrobond and Variant Perception