June 21, 2024
Investors

Investors still expect Fed to cut rates soon despite two reports showing inflation went up


Investors are shrugging off two reports this week that showed annual inflation ticked up last month, betting that the Federal Reserve will still soon cut interest rates.

The first and most closely watched report, the consumer price index, indicated that inflation ticked up to 3.4% for the year ending in December 2023, up from 3.1% the month before and hotter than economists had predicted. The producer price index, which gauges wholesale inflation, rose to 1% from 0.8% the month before.

On a monthly basis, which offers a more precise look at where inflation is, the CPI rose 0.3% in December. Crucially, the Fed sees healthy annual inflation being 2% price growth, so the uptick is unwelcome.

But investors brushed off the slight upswing in inflation and are still expecting the Fed’s first rate cut to come in March. In fact, after the reports showing inflation was, albeit slightly, moving in the wrong direction in December, the implied odds of a rate cut in March went up.

Investors now see a nearly 80% probability that the Fed will cut rates at its March meeting, according to the CME Group’s FedWatch tool, which calculates the probability using futures contract prices for rates in the short-term market targeted by the Fed. That is up from just 68% just a week ago.

Greg McBride, chief financial analyst at Bankrate, told the Washington Examiner that there is a bit of a mismatch between investor expectations of rate cuts and what the numbers on inflation are showing.

“Nothing economically is compelling the Fed to begin cutting rates right away,” he said. “The labor market is hanging in there, the members of the Fed have even come out and said that wage growth has to come down a little bit more, that the March timing might be too early. And yet investor expectations just continue to refute that.”

McBride said the United States has “seen this movie a few times before,” in which investors and the market are expecting the Fed to be more dovish, and yet the Fed has ended up throwing cold water on that notion — which has created some market volatility.

“It seems like we’re setting up for another episode of that,” he said.

It is crucial to note, though, that despite the unwelcome uptick in December, generally speaking, inflation has meaningfully fallen over the past year. Inflation peaked at about 9% in June 2022 and by January 2023 had dropped to 6.4% and by September 2023 it was registering at 3.7%.

Still, the Fed and Chairman Jerome Powell want to avoid an economically damaging scenario where they underestimate the staying power of the current inflationary bout and end up cutting rates too soon.

During the inflationary plague of the 1970s, inflation popped back up after periods of the Fed letting its foot off the gas. McBride said Powell and top officials have that history in the back of their minds.

“They’re keenly aware of that, and that’s one that the Fed has taken steps to avoid repeating, they’ve said as much about the missteps back in the ’70s and the desire not to repeat that — it’s certainly on their radar screen,” he said.

The mismatch between investors and the Fed extends through the entirety of 2024. The Fed itself, in its latest projections, is forecasting a total of about three rate cuts this year. Meanwhile, investors are predicting double that and expecting some six rate cuts.

“Today’s CPI report is a reminder that inflation, while improving, is not vanquished,” BOK Financial chief investment strategist Steve Wyett said. “Trends towards lower inflation, for the most part, remain intact, but it would seem a path of rate reductions closer to the Fed forecast, currently at three this year, makes more sense than the market’s more aggressive stance.”

Wyett said that the Fed’s projections seem more reasonable than those reflected in the markets.

One reason the Fed could end up cutting more than expected would be in the case of a recession, a scenario the central bank has worked hard to avoid. Cutting rates shores up growth, although many investors only expect a mild recession at worst while simultaneously predicting a positive year for the stock market.

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“If we get six rate cuts, it’s because something went wrong in the economy,” McBride said. “If we get six rate cuts, it’s because the economy tumbled into a recession, in which case you’re not going to get profit growth in stocks.”

Investors will be listening to the words of top Fed officials closely in the coming weeks, particularly the tone that Powell strikes following the Fed’s next meeting later this month. Incoming data for January will be crucial in indicating what might happen next for monetary policy.



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