Persistent Inflation Concerns Rise
U.S. Consumer Price Index Exceeds Expectations 3 months straight
The recent U.S. Consumer Price Index (CPI) data for March came in stronger than expected, leading to a broad resetting of expectations for when the Federal Reserve (Fed) will be able to cut rates this year. The CPI rose by 0.4% last month after advancing by the same margin in February. The annual rate of change in the CPI accelerated to 3.48% in March from 3.15% in February. Concerns are amplified now as it seems as if the CPI is stuck at a structural level around 3%.
Financial markets are now pricing in a September start to Fed rate cuts, with the U.S. rate futures market pricing in a 69% chance of a cut. Economists now predict only one or two rate cuts this year, down from the previously expected three, which is down from the previously expected six.
The CPI data has had a significant impact on global equities and Treasury yields. The bond market reacted to Wednesday's inflation report, with yields reaching their highest since November 2024. 2yr and 10yr yields posted their biggest daily gains since March 2023 and September 2022, respectively. As well a gauge of global equities slipped with the S&P 500 dropping almost 1% with roughly nine in every ten stocks losing ground.
Although CPI has been above expectation history shows that the core rate, like the headline rate, can go on multi-month runs that get everyone worked up about inflation pressures, only to disinflate all over again. As well, if inflation expectations were above 5% as many economists are predicting a second wave of inflation then we would expect the 10yr treasury yield to exceed this mark as well. With 10-year Treasury yield currently at 4.56%, it raises the question: Why would investors continue to hold this asset if they expected inflation to persist at 5% for the foreseeable future? Logically, one would expect long-term yields to exceed 5% if investors genuinely believed inflation would maintain this rate.
In contrast to the CPI data, U.S. Producer Price Index (PPI) data showed that producer prices rose moderately last month, with an increase in the cost of services being offset by falling goods prices. This softer than expected PPI report lessened the impact of the disappointing CPI report, indicating that progress on disinflation is stalling. The equity markets rebounded after the PPI data was reported.
Fed’s Outlook
Minutes from the Fed's March meeting revealed policymakers' disappointment with recent inflation readings before the latest report. A third straight month of hotter-than-expected prices likely sends officials back to an uneasy holding pattern where they wait several more months for either better inflation data or the type of evident economic weakness they were hoping to avoid.
This raises two different possibilities:
One is that the Fed's expectation that inflation continues to move lower but in an uneven and bumpy fashion is still intact, but with bigger bumps. In such a scenario, a delayed and slower pace of rate cuts is still possible this year.
A second possibility is that inflation, rather than on a bumpy path to 2%, is getting stuck at a level closer to 3%. Without evidence that the economy is slowing more notably, that could scrap the case for cuts altogether.
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