Economics
Hot inflation data pushes market’s rate cut expectations to September
Traders work on the floor of the New York Stock Exchange during afternoon trading on April 09, 2024 in New York City.
Michael M. Santiago | Getty Images
As recently as January, investors had high hopes that the Federal Reserve was about to embark on a rate-cutting campaign that would reverse some of the most aggressive policy tightening in decades.
Three months of inflation data have brought those expectations back down to earth.
March’s consumer price index report Wednesday helped verify worries that inflation is proving stickier than thought, giving credence to caution from Fed policymakers and finally dashing the market’s hopes that the central bank would be approving as many as seven rate cuts this year.
“The math suggests it’s going to be hard near term to get inflation down to the Fed’s target,” said Liz Ann Sonders, chief investment strategist at Charles Schwab. “Not that you’ve put a pin in inflation getting to the Fed’s target, but it’s not happening imminently.”
There was little good news to come out of the Labor Department’s CPI report.
Both the all-items and ex-food and energy readings were higher than the market consensus on both a monthly and annual basis, putting the rate of inflation well above the Fed’s target. Headline CPI rose 0.4% on the month and 3.5% from a year ago, ahead of the central bank’s 2% goal.
Danger beneath the surface
But other danger signs beyond the headline numbers emerged.
Services prices, excluding energy, jumped 0.5% and were up 5.4% from a year ago. A relatively new computation the markets are following which takes core services and subtracts out housing — it has come to be known as “supercore” and is watched closely by the Fed — surged at an annualized pace of 7.2% and rose 8.2% on a three-month annualized basis.
There’s also another risk in that “base effects,” or comparisons to previous periods, will make inflation look even worse as energy prices in particular are rising after falling around the same time last year.
All of that leaves the Fed in a holding position and the markets worried about the possibility of no cuts this year.
The CME Group’s FedWatch tool, which computes rate-cut probabilities as indicated by futures market pricing, moved dramatically following the CPI release. Traders now see just a slim chance of a cut at the June meeting, which previously had been favored. They have also pushed out the first reduction to September, and now expect only two cuts by the end of the year. Traders even priced in a 2% probability of no cuts in 2024.
“Today’s disappointing CPI report makes the Fed’s job more difficult,” said Phillip Neuhart, director of market and economic research at First Citizens Bank Wealth. “The data does not completely remove the possibility of Fed action this year, but it certainly lessens the chances the Fed is cutting the overnight rate in the next couple months.”
Market reaction
Markets, of course, didn’t like the CPI news and sold off aggressively Wednesday morning. The Dow Jones Industrial Average dropped by more than 1%, and Treasury yields burst higher. The 2-year Treasury note, which is especially sensitive to Fed rate moves, jumped to 4.93%, an increase of nearly 0.2 percentage point.
There could yet be good news ahead for inflation. Factors such as rising productivity and industrial capacity, along with slower money creation and easing wages, could take the pressure off somewhat, according to Joseph LaVorgna, chief economist at SMBC Nikko Securities.
However, “inflation will remain higher than what is necessary to warrant Fed easing,” he added. “In this regard, Fed cuts will be pushed out to into the second half of the year and are likely to fall only 50 basis points [0.5 percentage point] with risks being tilted in the direction of even less easing.”
In some respects, the market has only itself to blame.
The pricing in of seven rate cuts earlier this year was completely at odds with indications from Fed officials. However, when policymakers in December raised their “dot plot” indicator to three rate cuts from two projected in September, it set off a Wall Street frenzy.
“The market was just way over its skis in that assumption. That made no sense based on the data,” Schwab’s Sonders said.
Still, she thinks if the economy stays strong — GDP is projected to grow at a 2.5% rate in the first quarter, according to the Atlanta Fed — the knee-jerk reaction to Wednesday’s data could pass.
“If the economy hangs in there, I think the market is, for the most part, OK,” Sonders said.
Correction: The markets are worried about the possibility of no cuts this year. An earlier version misstated the worries.
The Federal Reserve’s key inflation measure rose more than expected in February while consumer spending also posted a smaller than projected increase, the Commerce Department reported Friday.
The core personal consumption expenditures price index showed a 0.4% increase for the month, putting the 12-month inflation rate at 2.8%. Economists surveyed by Dow Jones had been looking for respective numbers of 0.3% and and 2.7%.
Core inflation excludes volatile food and energy prices and is generally considered a better indicator of long-term inflation trends.
In the all-items measure, the price index rose 0.3% on the month and 2.5% from a year ago, both in line with forecasts.
At the same time, the Bureau of Economic Analysis report showed that consumer spending accelerated 0.4% for the month, below the 0.5% forecast. That came as personal income posted a 0.8% rise, against the estimate for 0.4%.
Stock market futures moved lower following the release as did Treasury yields.
Federal Reserve officials focus on the PCE inflation reading as they consider it a broader measure that also adjusts for changes in consumer behavior and places less of an emphasis on housing than the Labor Department’s consumer price index. Shelter costs have been one of the stickier elements of inflation and rose 0.3% in the PCE measure.
“It looks like a ‘wait-and-see’ Fed still has more waiting to do,” said Ellen Zentner, chief economic strategist at Morgan Stanley Wealth Management. “Today’s higher-than-expected inflation reading wasn’t exceptionally hot, but it isn’t going to speed up the Fed’s timeline for cutting interest rates, especially given the uncertainty surrounding tariffs.”
Good prices increased 0.2%, led by recreational goods and vehicles, which increased 0.5%. Gasoline offset some of the increase, with the category falling by 0.8%. Services prices were up 0.4%.
The report comes with markets on edge that President Donald Trump’s tariff intentions will aggravate inflation at a time when the data was making slow but steady progress back to the Fed’s 2% goal.
After cutting rates a full percentage point in 2024, the central bank has been on hold this year, with officials of late expressing concern over the impact the import duties will have on prices. Economists tends to consider tariffs as one-off events that don’t feed through to longer-lasting inflation pressures, but the encompassing scope of Trump’s tariffs and the potential for an aggressive global trade war are changing the stakes.
Correction: Consumer spending increased 0.4% in February. An earlier headline misstated the number.
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