Hot inflation data pushes market interest rate cut expectations into September

Last January, investors had high hopes that the Fed was about to embark on an interest rate-cutting campaign that would reverse some of the most aggressive tightening policies in decades.

Three months of inflation data have brought these expectations back to reality.

The March CPI report on Wednesday helped validate fears that inflation was proving more persistent than thought, giving credence to caution on the part of Federal Reserve policymakers and finally dashing market hopes that the central bank would approve up to Seven interest rate cuts this year.

“Calculations indicate that it will be difficult in the near term to bring inflation down to the level the Fed is targeting,” said Liz Ann Saunders, chief investment strategist at Charles Schwab. “Not that you've put a pin on inflation reaching the Fed's target, but it's not imminent.”

There was little good news to come out of the Labor Department's Consumer Price Index report.

The readings for all items and the previous food and energy readings were above the market consensus on a monthly and annual basis, keeping the inflation rate well above the Fed's target. The headline consumer price index rose 0.4% month-on-month and 3.5% compared to a year ago, ahead of the central bank's target of 2%.

But other danger signs have emerged beyond the headline numbers.

Service prices, excluding energy, jumped 0.5% and rose 5.4% compared to last year. The relatively new calculation tracked by markets that takes basic services and excludes housing — it has become known as “supercore” and is closely watched by the Fed — has risen at an annualized pace of 7.2% and is up 8.2% year over year. -Month to yearly basis.

There is also another risk that “base effects”, or comparisons with previous periods, will make inflation look worse with energy prices in particular rising after falling around the same time last year.

All of this leaves the Fed holding on and markets concerned about the possibility of no cuts this year.

CME Group's FedWatch tool, which calculates the probabilities of interest rate cuts as reflected in futures market pricing, moved significantly after the CPI release. Traders now see little chance of a cut at the June meeting, which was previously favourable. They also postponed the first cut to September, and now expect only two cuts by the end of the year. Traders even predicted a 2% chance of no discounts in 2024.

“Today’s disappointing CPI report makes the Fed’s job even more difficult,” said Philip Newhart, director of market and economic research at First Citizens Wealth Bank. “The data doesn't completely eliminate the possibility of the Fed taking action this year, but it certainly reduces the chances of the Fed making an overnight rate cut in the next two months.”

Naturally, the markets did not like the CPI news and sold off heavily on Wednesday morning. the Dow Jones Industrial Average They fell by more than 1%, and Treasury yields rose. the Two-year Treasury bondswhich is particularly sensitive to movements in the federal funds rate, jumped to 4.93%, an increase of about 0.2 percentage points.

There could be good news in the future regarding inflation. Factors such as increased productivity and industrial capacity, coupled with slower money creation and easing wages, could ease the pressure somewhat, according to Joseph LaVorgna, chief economist at SMBC Nikko Securities.

“Inflation will remain higher than is necessary to justify Fed easing,” he added. “In this regard, the Fed’s cuts will be extended into the second half of the year and are likely to fall by just 50 basis points (0.5 percentage points) with risks tilted in a less accommodative direction.”

In some ways, the market only has itself to blame.

The pricing of seven interest rate cuts earlier this year was completely at odds with Fed officials' indications. However, when policymakers in December raised the “chart point” indicator to three rate cuts from two expected in September, it sent Wall Street into a frenzy.

“The market was over its skis on that assumption. It didn't make sense based on the data,” Schwab's Saunders said.

However, she believes that if the economy remains strong — gross domestic product is expected to grow at a rate of 2.5% in the first quarter, according to the Federal Reserve Bank of Atlanta — the knee-jerk reaction to Wednesday's data may pass.

“If the economy stays there, I think the market is in good shape for the most part,” Saunders said.

Correction: Markets are concerned about the possibility of no cuts this year. An earlier version misstated the concerns.