Investors are ignoring two reports this week that showed annual inflation rose last month and are betting that the Federal Reserve will cut interest rates again soon.
The first and most closely watched report, the consumer price index, suggested inflation rose to 3.4% for the year ending December 2023, up from 3.1% the previous month and hotter than economists had predicted. The producer price index, which measures wholesale inflation, rose to 1% from 0.8% the previous month.
On a monthly basis, which provides a closer look at the inflation rate, the consumer price index rose 0.3% in December. Crucially, the Fed assumes 2% price growth is a healthy annual inflation rate, making the increase undesirable.
But investors ignored the slight increase in inflation and continue to expect the Fed's first interest rate cut in March. After reports showed inflation moving in the wrong direction, albeit slightly, in December, the implied odds of a rate cut in March actually increased.
Investors now see a nearly 80% chance that the Fed will cut interest rates at its March meeting, according to CME Group's FedWatch tool, which calculates probability using futures contract prices for interest rates in the Fed's targeted short-term market . That's up from just 68% a week ago.
Greg McBride, chief financial analyst at Bankrate, told the Washington Examiner that there is some disconnect between investors' expectations of interest rate cuts and inflation numbers.
“Economically speaking, there is no reason for the Fed to start cutting rates immediately,” he said. “The labor market is holding up, Fed members have even come out and said that wage growth still needs to slow down a bit and that the timing of March may be too early. And yet investor expectations continue to belie this.”
McBride said the United States has “seen this movie a few times” in which investors and the market expect a more dovish stance from the Fed, and yet the Fed ultimately poured cold water on that notion – creating some market volatility .
“It seems like we’re getting ready for another episode of this,” he said.
However, it is important to note that despite the unwelcome spike in December, inflation generally fell significantly last year. Inflation peaked at around 9% in June 2022 and fell to 6.4% in January 2023 and 3.7% in September 2023.
Still, the Fed and its Chairman Jerome Powell want to avoid an economically damaging scenario in which they underestimate the staying power of the current surge in inflation and end up cutting interest rates too early.
During the inflationary plague of the 1970s, inflation rose again after the Fed temporarily took its foot off the gas. McBride said Powell and top officials had that story in mind.
“They are fully aware of this and the Fed has taken steps to avoid a repeat. They've also said this about the missteps 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 throughout 2024. The Fed itself predicts a total of about three interest rate cuts for this year in its latest forecasts. Meanwhile, investors are forecasting double that and expecting around six rate cuts.
“Today's CPI report is a reminder that while inflation is improving, it is not defeated,” said Steve Wyett, chief investment strategist at BOK Financial. “The trend toward lower inflation remains largely intact, but it appears that a path of rate cuts closer to the Fed's forecast, currently at three this year, makes more sense than the market's more aggressive stance.”
Wyett said the Fed's forecasts appear more reasonable than those reflected in markets.
One reason the Fed could end up cutting interest rates more than expected would be in the event of a recession, a scenario the central bank has worked hard to avoid. Interest rate cuts are supporting growth, although many investors expect only a mild recession in the worst-case scenario while 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 has slipped into recession. In that case, you won’t get earnings growth in stocks.”
Investors will be listening closely to words from senior Fed officials in the coming weeks, particularly the tone Powell takes after the Fed's next meeting later this month. The upcoming data for January will be crucial in determining what might happen next in monetary policy.