Thursday’s inflation report could cast doubt on the market’s view of a big Fed rate cut

Consumers shop at a retail chain in Rosemead, California on December 12, 2023.

Frederic J. Brown | AFP | Getty Images

Economists expect inflation to have picked up in December, a trend that could challenge the market’s eager expectation that the Federal Reserve will cut interest rates this year.

The consumer price index, a widely watched measure of the cost people pay for a wide range of goods and services, is expected to rise 0.2% in the final month of 2023, or 3.2% for the year, according to Dow Jones.

At a time when the Fed is fighting inflation through tight monetary policy, including increased rates, news that prices are holding at high levels could be enough to disrupt already fragile markets.

“The Fed has made a policy change and the data needs to support that pivot,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “The market seems to have been excited that the Fed is going to have to do more than the Fed thinks in terms of cutting rates now. … The market got ahead of itself.”

There is certainly a wide gap between what the Fed has indicated in terms of rate cuts and what the market expects.

After months of insisting that looser monetary policy was still the way to go, central bankers in December moved to cut rates by three-quarters of a percentage point by the end of 2024, essentially a key point for this anti-inflation era. Minutes of that meeting released last week did not indicate any discussion of a timetable for cuts.

The markets have a different view.

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Traders in the federal funds futures market point to a strong chance of an initial rate cut in March, followed by five more cuts over the course of the year, which would bring the benchmark overnight rate down to a range of 3.75% to 4%. according to the CME Group’s FedWatch gauge.

If inflation data like Thursday morning’s CPI release and Friday’s producer price index don’t show stronger inflation developments, it could cause more volatility in a year where stocks have already gotten off to a rocky start.

“We’re going to see that in all markets because it’s going to be that dynamic between what the Fed does and what the market expects them to do,” McIntyre said of the likely volatile period ahead. “Eventually they have to get their act together. That probably means right now the market has to give back some of the rate cuts that they priced in.”

The flurry of public statements since the Federal Open Market Committee meeting in December has given little indication that officials are ready to let up.

Fed Governor Michelle Bowman said this week that while she expects a rate hike, she doesn’t see a reason to cut yet. Similarly, Dallas Fed President Lorie Logan, in more dovish anti-inflation remarks on Saturday, said that easing financial conditions, such as a strong stock market recovery in 2023 and a year-end decline in Treasury yields, raised the specter that inflation could play out. recovery.

“If we don’t keep financial conditions tight enough, there is a risk that inflation will pick up again and reverse the progress we’ve made,” Logan said. “In light of the easing of financial conditions in recent months, we should not yet take the possibility of further rate increases off the table.”

Finding balance

But Logan conceded it might be time to think about slowing the pace of the Fed’s balance sheet reduction. Dubbed “quantitative tightening,” the process involves allowing the proceeds of maturing bonds to withdraw without reinvesting them and has reduced the central bank’s holdings by more than $1.2 trillion since June 2022.

The Fed’s central mission now is to calibrate policy so that it does not loosen too much and allow inflation to return, keeping policy too tight to cause a long-awaited recession.

“The policy is too restrictive given where inflation is and where it’s likely to go,” said Joseph Brusuelas, chief economist at tax consultancy RSM. “The Fed is clearly positioned to put a floor on the economy during the second half of the year with rate cuts and set the stage for the economy to pick up again later this year or next.”

Still, Brusuelas thinks the market is too aggressive on pricing in the six rate cuts. Instead, he expects perhaps four moves as part of a gradual normalization process involving both rates and the unwinding of the balance sheet.

As for the inflation news, Brusuelas said the results are likely to be nuanced, with some gradual movements in the headline numbers and likely more focus on internal data such as shelter costs and used vehicle prices. Core inflation, which excludes volatile food and energy prices, is also expected to rise 0.3% month-on-month, to a 3.8% rate from a year earlier, which would be the first below 4% since May 2021.

“We will have an intense market debate about whether to return to 2% on a permanent basis,” Brusuelas said. “They will need to see this improvement to set the predicate for the QT adjustment.”

Former Fed vice chairman Richard Clarida said policymakers will likely be more cautious. He also expects just three cuts this year.

“There’s certainly been progress in inflation over the last six months … There’s always good news and bad news,” Clarida said Wednesday on CNBC’s “Squawk on the Street.” “Markets may be a little relaxed about where inflation is sticky and stubborn. But the data is definitely moving in a direction that is favorable to the economy and the Fed.”

Expect the Fed to ease policy three times this year: PIMCO's Richard Clarida

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