Markets Are Jumping the Fed’s 25bp Gun

Summary

• US inflation data came in on Thursday, showing cooling headline and core prints.
• The main pattern from November persisted: core goods price deflation, accelerating shelter inflation, and no let-up in services inflation ex shelter.
• Slowing energy price inflation keeps dragging down core inflation, in line with the greater co-movements of the CPI components under a high inflation regime.

Market Implications

• Markets pounced on the inflation data to price in a 25bp hike at the February FOMC meeting.
• But I still expect a 50bp hike because Q4 GDP data, due out ahead of the meeting, is likely to remain well above trend.

Core Goods Deflation Continues

The market was quick to celebrate Thursday’s inflation data. After the Consumer Price Index (CPI) matched expectations at -0.1% MoM for headline and 0.3% MoM for core, the S&P 500 (SPX) ended the day up 0.3% and the dollar (BBDXY) down 0.75%.

More significantly, the cooling figures prompted many – including Fed President Patrick Harker – to call for a deceleration in Fed hiking at the next meeting on 1 February. I remain unconvinced, however, with my eyes on a potentially surprising GDP data release due just days before Fed’s big call.

Digging Into the Numbers

As in November, core goods deflation offset strong core services inflation. Core goods inflation was -34bps, up from -52bps in November. Used car prices remained a key driver of core goods deflation. They continued to fall, -2.55% MoM against -2.95% in November, and their contribution to core goods inflation was -44bps.

Used car prices likely have further to fall as the ratio of used to new prices remains well above pre-pandemic levels and new car prices remain stable (Chart 1). Core goods inflation excluding used cars could be stabilizing, though it is too early to tell.

Rent Inflation Continues to Accelerate

Shelter inflation accelerated to 80bps MoM from 65bps in November. This consistent with my expectations that it would stabilize only around end-2023.

Since the 1970s, shelter costs have become much more responsive to wage growth than to property prices (Chart 2). Meanwhile, wage growth remains high (measured by the Atlanta Fed median wage, since falling overtime hours are suppressing payrolls wages).

Services Inflation Ex Shelter Accelerated

Core services ex shelter accelerated to 21bps MoM, up from 15bps in November. Medical services and transportation, which each account for about a fourth of core services ex shelter weights, increased by 9 and 19bps, against declines of 67 and 8bps in November respectively

On a YoY basis, core services inflation ex shelter remains closely correlated to wages (Chart 3). Though median wage growth has slowed, and core services inflation ex shelter has stabilized, both remain well above levels consistent with 2% inflation.

Overall, the slowdown in core inflation likely reflects the slowdown in energy inflation. When inflation is high, energy and core inflation become correlated (Chart 4). This likely reflects the higher correlation across price categories typical of a high inflation regime (see this BIS study).

Market Consequences

Following the CPI print, markets repriced the Fed lower; bonds and stocks rose. That aligns with a return of Goldilocks in Q1. The OIS-based peak federal fund rate (FFR) fell about 4bps, the end-2023 FFR 6bps, the 2yr yield 8bps and the 10yr 10bps. Markets are currently pricing about 25bps at the 1 February Fed meeting.

So far this month, regional Fed Presidents Collins, Bostic, Cook, Barkin, Daly (non-voters), and Harker (voter), have supported or, based on the CPI, are likely to support 25bps in February.  By contrast, Bullard (non-voter) is arguing for 50bps.

Despite Thursday’s CPI print and the dovish comments from the regional Fed presidents, I still expect a 50bp hike in February. This is because I expect Q4 GDP (due on 26 January) to be well above the FOMC estimate of trend of 1.8%. As a result, the more economically minded and more influential voters, i.e., Powell, Waller, Williams and perhaps even Brainard, are likely to become more concerned over risks of wages recovery and support 50bps.

In addition, a strong Q4 GDP print would reinforce Fed concerns over an easing of financial conditions. Goldman Sachs’ Financial Conditions Index is back to the level prevailing in October, when the FFR was 125bp lower than currently. A Fed pre-announcement of a 25bp hike would likely see financial conditions ease further.  

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)