Merchants improve possibilities of Fed fee minimize after inflation report

Shoppers during the grand opening of a Costco wholesale store in Kyle, Texas on Thursday, March 30, 2023.

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Despite inflation being well above the Federal Reserve’s target, markets were more confident on Wednesday that the central bank will cut interest rates as early as September.

Annual CPI inflation fell to 4.9% in April, the lowest in two years but still more than double the Fed’s 2% target.

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Still, it was enough for traders to push the odds of a September rate cut to nearly 80%, according to CME Group’s Fed Watch tracker of Fed funds futures market prices. In fact, the October Fed Funds contract implied a policy rate of 4.84%, nearly a full quarter point below the current effective rate of 5.08%.

However, among Wall Street analysts and economists, the case for a rate cut remains uncertain.

“The timing of an initial rate cut will depend on both how quickly inflation slows and how quickly the labor market eases,” said Bill Adams, chief economist at Comerica Bank. Weaker employment and a further decline in inflation “would allow the Fed to start cutting rates as early as the fall.”

However, even if central bankers decide they can halt hikes for the time being, the hurdle to a rate cut appears high.

New York Fed President John Williams, an influential policymaker and constituent on the Federal Open Market Committee that sets interest rates, said Tuesday he does not expect any monetary easing at all this year, although he left the possibility open beyond that .

“My prediction is that we’ll have to hold tightening policies for quite some time to make sure we’re really cutting inflation,” he said in an appearance before the Economic Club of New York. “I see no reason in my baseline forecast to cut rates this year.”

Still, markets are pricing in multiple rate cuts totaling 0.75 percentage points in 2023, which would bring the Fed’s policy rate to a target range of 4.25% to 4.5%. The central bank raised interest rates by a quarter point to 5.0% to 5.25% last week, the tenth hike since March 2022.

Policymakers are likely to continue to crush these expectations of looser policy over the coming months, even if they choose not to raise rates.

“What’s really pushing them back is our expectation in the market that they’re going to slow down. But they don’t promote the notion that peak interest rates will be higher,” said Paul McCulley, a former chief executive of Pimco and currently a senior fellow in financial macroeconomics at Cornell University, on CNBC’s Squawk on the Street on Wednesday.

“They’re going to be sounding pretty hawkish until they get some clear evidence that we really are where we want to be,” McCulley said, using a market term for favoring higher interest rates and tighter monetary policy.

The April CPI report provided mixed signals on the trajectory of inflation, with the core reading, excluding food and energy costs, remaining relatively stable at 5.5% yoy.

Additionally, a measure of the Atlanta Fed’s “sticky consumer price index,” which measures prices that don’t change much, was only marginally lower at 6.5% in April. The flexible-price CPI, which measures more volatile items such as food and energy costs, rose to 1.9%, up 0.3 percentage point.

“The fact that the annual pace of core inflation remains well above the Federal Reserve’s 2% target and shows no sign of a downtrend is crucial,” wrote Kurt Rankin, chief economist at PNC, in response to the CPI data. “Cuts on this front will be needed before any change in Fed policy rhetoric is expected.”

Ahead of the CPI release, markets had priced in about a 20% chance of a rate hike at the June 13-14 FOMC meeting. After the session, that probability dropped to just 8.5%.

This happened even though “the previous downward trend in inflation has temporarily stalled,” wrote Andrew Hunter, deputy chief economist at Capital Economics.

“We don’t think this will persuade the Fed to hike rates again at the June FOMC meeting, but it does suggest there is a risk that rates will have to stay high a little longer than we thought,” he said Hunter.

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