If nothing else, the January inflation report released Tuesday finally appears to have convinced markets that Federal Reserve officials weren't kidding around when they said they will take a deliberate approach to cutting interest rates this year. Following the consumer price index report showing the year-over-year reading well ahead of the Fed's desired inflation goal, markets recalibrated their monetary policy expectations. Where only a few weeks ago traders in the fed funds futures market were assigning a near certainty to a March beginning of an aggressive rate-cutting cycle, they now have taken such a possibility off the table, according to the CME Group. Ditto for May — and June could be next if the data continues to reinforce Fed fears that it's too soon to declare victory in the inflation fight, according to a variety of commentary and client notes released after the Labor Department's CPI reading. "Progress towards the central bank's inflation target of 2% is ongoing, but challenges remain, particularly the so-called 'last mile problem,'" said Sung Won Sohn, professor of finance and economics at Loyola Marymount University and chief economist of SS Economics. The Fed "faces a challenging task in balancing economic growth and employment while trying to control inflation," he added. "A careful and nuanced approach may be necessary, potentially delaying interest rate cuts until there is clear evidence that inflation is consistently moving towards the target." Persistent inflation On its face, the CPI report wasn't terrible: The headline CPI increased 3.1% from a year ago, down from the 3.4% rate in December and seemingly edging closer to the Fed's 2% goal. On a monthly basis, CPI rose 0.3%, up one-tenth of a percentage point from a month ago. The core numbers, though, were more concerning, at 3.9% and 0.4% respectively. All the rates were higher than the Dow Jones consensus estimates collected from economists. But the details were even more troubling. Shelter prices rose 0.6% for the month and were still up 6% on the year. Owners equivalent rent, a hypothetical gauge of what homeowners think they could get on the rental market, also moved up 0.6% on the month, even as the Fed is betting on a consistent pullback in housing costs this year. Moreover, services excluding energy costs jumped 0.7% monthly, up sharply from the 0.4% December level, and rose 5.4% for the 12 months, reversing a decline that started in February 2023. Put it all together and you get a market rethinking its gamble on lower rates, and paying more heed to statements from Chair Jerome Powell and others that the Fed will take its time this year in contemplating when and how it will loosen policy. "Evidence of still-sticky services inflation is likely to give the Fed pause before cutting rates too quickly, especially as it tries to avoid paring back on tight policy too quickly and risk another wave of inflation," said Jason Pride, chief of investment strategy and research at Glenmede. "Rate cuts are likely still on the table for this year, but they may begin later in 2024 than the market may be anticipating." Markets voiced their concerns loudly after the report. Major averages on Wall Street fell more than 1% apiece while yields on the Fed-sensitive 2-year Treasury note surged to their highest level since mid-December. US2Y 3M line 2 year note Several economists urged caution on reading too much into one report and said there's still reason to believe housing data and broader inflation readings will ease through the year. Warnings from Powell However, the latest developments "will provide further vindication to [Powell's] cautious stance on policy and supports the narrative that officials will need to see more evidence of disinflation before committing to lower rates," said Matthew Ryan, head of market strategy at global financial services firm Ebury. "We feel like we can approach the question of when to begin to reduce interest rates carefully," Powell said earlier this month during an interview on CBS' "60 Minutes." "We want to see more evidence that inflation is moving sustainably down to 2%." Indeed, the narrative of the Fed being able to start cutting early, and moving rapidly through the year, was all but dead Tuesday. Economists at both Bank of America and Citigroup said they now expect the first cut to be delayed until June. That June call, as opposed to March previously, is now a more popular view on the Street. The January CPI report is a "setback for the Fed and makes a May rate cut unlikely. Given strong growth and employment the Fed is likely to want to wait until June to confirm that inflation is moving back durably to 2% and we confirm June as our base case," said Krishna Guha, head of global policy and central bank strategy at Evercore ISI. Guha added that inflation may be hotter than previously thought "and the Fed might have to revise its plan more profoundly, though we think it would be entirely unwarranted to jump to that conclusion on the basis of this one report."
