Fed Meeting: Soft CPI Sets Stage For Hawkish Surprise

Tuesday’s soft CPI inflation data may have thrown investors a curveball ahead of today’s Fed meeting. The S&P 500 initially surged on the data as markets priced in a lower peak for the Federal Reserve’s key interest rate.

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Yet there’s good reason to doubt that Fed chair Jerome Powell will be swayed by the tamer readings for the consumer price index and core CPI inflation. In fact, Powell gave a speech on Nov. 30 explaining why those are wrong inflation rates for the Fed to consider.

There’s little doubt that the Fed will step down its pace of hiking today, with a half-point increase. That will lift the federal funds rate to a range of 4.25% to 4.5%.

Fed Meeting To Clarify Rate-Hike Outlook

But the November CPI report, which showed the inflation rate easing to 7.1% from 7.7%, may have shifted expectations too far for the next Fed meeting and for the peak rate of the cycle.

After the core CPI rose just 0.2% from October, markets are pricing in 62% odds that the Fed will only hike by 25 basis points on Feb. 1. But it’s possible that Powell will use his 2:30 p.m. news conference to hint at another half-point hike, barring unexpected developments, such as job gains turning to job losses.

Along with the 2 p.m. ET policy statement, the Fed also will release quarterly economic projections, including the outlook for interest rates. At the September meeting, policymakers penciled in a peak rate of 4.6% in 2023. Markets now see the Fed’s key rate peaking at 4.9% in May, down from about 5.05% before the CPI report, according to CME Group’s FedWatch page.

Yet today’s Fed projections could show the federal funds rate modestly above 5% through the end of next year.

If Fed guidance does prove more hawkish than markets expect, it probably won’t bruise the S&P 500 too badly in Wednesday stock market action. With inflation falling, markets could stay in a festive mood.

Yet Powell, as he did last month, will likely make the case for holding interest rates higher for longer, shifting the focus from the CPI to wage growth. That would probably keep a lid on the current rally.

The Fed’s New Key Inflation Rate

The specific inflation rate that Powell says the Fed and Wall Street should focus on comes from the Commerce Department’s monthly personal income and spending report, which tracks personal consumption expenditures, or PCE.

Powell’s favorite new inflation rate happens to be the most problematic one for the S&P 500. The gauge factors out goods inflation, which is rapidly falling. It also excludes housing inflation, which appears set to fall in 2023 as government data catches up to the stalling growth of market rents.

That leaves only core services other than housing, such as health care, education, hospitality and haircuts. Because price changes for such services are closely linked to wage growth, they provide the best signal of where core inflation is heading, Powell said.

The Fed’s new key inflation rate isn’t great for the S&P 500 because it puts the focus on the strongest part of the economy: the tight labor market. Until the job market cracks, wage growth is likely to remain stubbornly high, and the Fed may hike its benchmark interest rate higher and for longer than markets anticipate.

The CPI report showed that core services prices excluding shelter were flat in November vs. the prior month. But the similar PCE index won’t be quite that tame. That’s partly because the two indexes measure health care services inflation in much different ways, with the PCE measure more reflective of wage pressures. The CPI medical care services index fell 0.7% in November, the largest-ever monthly decline.

S&P 500 Near Key Level

S&P 500 futures rose 0.4% in early Wednesday stock market action, following Tuesday’s 0.7% gain. The S&P 500 had climbed nearly 3% at its morning highs after the tame CPI. But investors probably didn’t want to be caught wrong-footed by a hawkish Fed meeting.

The Dow Jones Industrial Average also rose 0.4%, while the Nasdaq composite inched 0.1% higher.

The S&P 500 pushed past its 200-day line intraday on Tuesday, before closing below the key technical level. The past several rally attempts back to April have stalled out at the 200-day moving average.

All the major indexes hit resistance at their Dec. 1 highs on Tuesday.

Through Tuesday’s close, the S&P 500 has rallied 10% from its Oct. 12 bear-market closing low. Still, the S&P 500 remains 18% below its record high on Jan. 3. The Dow Jones has climbed 16.5% since hitting bottom, leaving it just 9% off its all-time high. The Nasdaq has bounced 6.6% but remains 31.5% below its peak.

Be sure to read IBD’s The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.

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