Consumers shop at a retail chain store in Rosemead, California, on Dec. 12, 2023.
Frederic J. Brown | AFP | Getty Images
Economists expect that inflation nudged higher in December, a trend that could call into question the market’s eager anticipation that the Federal Reserve will slash interest rates this year.
The consumer price index, a widely followed measure of the costs folks pay for a wide range of goods and services, is projected to have risen 0.2% in the final month of 2023, or 3.2% for the full year, according to Dow Jones.
At a time when the Fed is fighting inflation through tight monetary policy including elevated rates, news that prices are holding at high levels could be enough to disrupt already-fragile markets.
“The Fed did its policy pivot, and the data’s got to support that pivot,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “The market seems to have gotten excited that the Fed’s going to have to do more than what the Fed thinks in terms of rate cuts 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 is expecting.
After months of insisting that easier monetary policy is still a ways off, central bank policymakers in December penciled in three quarter-percentage-point rate cuts by the end of 2024, effectively a policy pivot for this inflation-fighting era. Minutes from that meeting released last week did not indicate any discussion about a timetable for the reductions.
Markets hold a different view.
Looking for easing
Traders in the fed funds futures market are pointing to a strong chance of an initial rate cut in March, to be followed by five more reductions through the year that would take the benchmark overnight borrowing rate down to a range of 3.75% to 4%, according to the CME Group’s FedWatch gauge.
If inflation data such as Thursday morning’s CPI release and Friday’s producer price index don’t show stronger inflation progress, that is liable to cause more volatility in a year when stocks have already gotten off to a rocky start.
“We’re going to see it across all markets, because it’s going to be that dynamic between what the Fed’s doing and what the market expects them to do,” McIntyre said of a likely volatile time ahead. “Ultimately, they’ve got to come together. It probably means that right now, the market needs to give back some of the rate cuts that they priced in.”
A smattering of public statements since the December meeting of the Federal Open Market Committee provided little indication that officials are ready to let down their guard.
Fed Governor Michelle Bowman said this week that while she expects rate hikes could be done, she doesn’t see the case yet for cuts. Likewise, Dallas Fed President Lorie Logan, in more pointed remarks directed at inflation, said Saturday that the easing in financial conditions, such as 2023’s powerful stock market rally and a late-year slide in Treasury yields, raise the specter that inflation could see a resurgence.
“If we don’t maintain sufficiently tight financial conditions, there is a risk that inflation will pick back up and reverse the progress we’ve made,” Logan said. “In light of the easing in financial conditions in recent months, we shouldn’t take the possibility of another rate increase off the table just yet.”
The search for balance
Logan, however, did concede that it could be time to think about slowing the pace of the Fed’s balance sheet reduction. The process, nicknamed “quantitative tightening,” involves allowing proceeds from maturing bonds to roll off without reinvesting them, and has cut the central bank’s holdings by more than $1.2 trillion since June 2022.
The Fed’s central mission now is calibrating policy in a way that it doesn’t ease too much and allow inflation to return or hold policy too tight so that it causes a long-anticipated recession.
“Policy is too restrictive given where inflation is and likely where it’s going,” said Joseph Brusuelas, chief economist at tax consultancy RSM. “The Fed is clearly positioning itself to put a floor under the economy as we head into the second half of the year with rate cuts, and create the conditions for reacceleration of the economy later this year or next year.”
Still, Brusuelas thinks the market is too aggressive in pricing in six rate cuts. Instead, he expects maybe four moves as part of a gradual normalization process involving both rates and the rollback of the balance sheet reduction.
As for the inflation reports, Brusuelas said the results likely will be nuanced, with some gradual moves in the headline numbers and likely more focus on internal data, such as shelter costs and the prices for used vehicles. Also, core inflation, which excludes volatile food and energy prices, is expected to increase 0.3% on the month, equating to a 3.8% rate compared to a year ago, which would be the first sub-4% reading since May 2021.
“We’re going to have a vigorous market debate on whether we’re going back to 2% on a durable basis,” Brusuelas said. “They’ll need to see that improvement in order to set the predicate for modifying QT.”
Former Fed Vice Chair Richard Clarida said policymakers are more likely to take a cautious approach. He also expects just three cuts this year.
“The progress on inflation for the last six months is definitely there. … There’s always good news and bad news,” Clarida said Wednesday on CNBC’s “Squawk on the Street.” “Markets maybe are a little relaxed about where inflation is sticky and stubborn. But the data is definitely going in the direction that’s favorable for the economy and the Fed.”
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