Will the Fed Douse Burning Hot Inflation With Higher Rates?

The Bureau of Labor Statistics released the consumer price index for January, and it came in higher than expectations in every way. The year-over-year headline number came in at 7.5% vs. 7.2%, but perhaps more importantly, the monthly rate excluding food and energy also beat, coming in at 0.6% vs. 0.5% expected. Does this cement a 50-basis point rate hike from the Federal Reserve in March? Here are my thoughts.

Inflation isn't slowing, it is accelerating

It remains the market's consensus that inflation will subside over the course of 2022. Pricing on TIPS suggest that CPI will end 2022 at around 4%. That may well happen, but for the moment inflation isn't slowing at all. In recent months it has accelerated. Over the last 3-months, Core CPI is up 6.9% annualized, faster than the 12-month pace of 6.0%. To be fair, CPI can bounce around. The same 3-month annualized number would have been 10% in June. Of course, that was coming off the heels of stimulus checks hitting in March and April. Notably this recent acceleration is happening while fiscal thrust has been waning.

Does this clinch a 50bps hike in March?

Going into this number, markets were pricing about 1.3 hikes for March, or roughly a 30% chance of a 50bps hike. Right after the release that jumped to about 50%.

What we know right now is that a 50bps hike is definitely under consideration. Over the last few weeks, Fed Chairman Jerome Powell has had opportunities to tamp down 50bps speculation and he has not. He was asked directly about it during the January Federal Open Market Committee presser and made a point to say anything is possible. He also spoke during his Congressional testimony and again emphasized that everything is on the table. The Powell Fed has always tried to carefully manage expectations, so if they knew March was only going to be a 25bps hike, they'd be out messaging that now. They aren't, so we can only conclude that they haven't made up their collective minds just yet. This could be one of the few times in recent years where we go into a FOMC meeting unsure of what the outcome will be.

Eurodollar curve starting to invert

Eurodollar futures are a common way traders will bet on Fed policy in the future. These contracts settle in the three-month London Inter-Bank Offered Rate, which closely tracks Fed funds.

This curve has started to invert in recent days, which suggests markets think the Fed might start cutting rates before too long. As of right now, the rate for year-end 2023 is higher than for any subsequent year. The chart below shows the projected rate for each year-end as of now (orange) and as of a week ago (blue).

(source=Bloomberg)

New market basket could over (or under) state inflation going forward

The CPI is based on a "market basket" of goods with weightings meant to represent a typical consumer's consumption habits. Every two years this basket is updated based on new consumer surveys, but with a two year lag. This means that for 2022 (and 2023) the "market basket" will be based on consumer spending patterns from 2019 and 2020.

You may remember that 2020 was quite an unusual year for spending. Spending on goods surged while spending on services plunged. That's going to be reflected in the CPI for the next two years. The weight of all goods other than food/energy will be 1% higher going forward, shelter about 0.6% higher, while general services about 0.7% lower. Some specifics are interesting also. Used + new cars are now going to be almost 1% higher. Food away from home is 1% lower. Recreation is 0.6% lower. You get the idea.

There's obviously a risk that consumer spending habits from 2019-2020 aren't representative of 2022-2023. That could lead to CPI understating inflation. It might be that spending on certain large ticket items falls causing those prices to decline, while higher demand for services (plus perhaps continued wage growth) pushes up the price of services. If that happens, the new basket will overweight the declining large ticket items and underweight services.

For what it's worth, this is one major reason why the Fed prefers the personal consumption expenditures-based inflation estimate. The PCE market basket is updated in real-time based on actual purchases, while the CPI is based on a survey of consumer habits. If the two measures start to diverge substantially, PCE is the one to watch most closely.

Wages, spending remain key

Getting back to the Fed, it is going to be looking for data points that help them determine what the trend of inflation is. This CPI report merely tells us that inflation has been very high, but doesn't tell us that much about where it is going.

For that I think we need to be watching measures of household income and spending. Prices will keep rising at an elevated pace as long as consumer spending is outstripping the economy's ability to supply goods and services. So any signs of slowing consumer spending could indicate that inflation is starting to subside. The December retail sales and personal spending reports were both a bit weak. January's figures for both will help us determine if that was a one-off or if it is the start of a trend. Retail sales comes out next Wednesday, so expect that to be a major market mover.

Obviously consumer spending can't keep growing if consumer income doesn't also grow. At one time many (including me) assumed that spending would plunge after the effect of stimulus checks faded. But now nearly a year after the last checks were mailed, the pace of consumption remains far above pre-pandemic trend. Now the only thing that can continue to boost consumer spending is wage growth.

I feel very confident that wage growth will remain robust, as labor demand remains well in excess of labor supply. It is harder to know for sure how this will translate into consumer spending. Many argue that consumption is still being boosted by lingering effects of stimulus, perhaps because some of those extra payments were initially saved and subsequently spent over time. While there's probably something to that, I think that rising incomes will support spending staying at least steady. We know that current levels of spending are creating current levels of inflation, so I'm inclined to assume that if current levels of spending remain about the same, so will inflation.

At the time of publication, Graff was short 5-year, 10-year and Ultra 10-year Treasury futures.