Inflation will keep a hawkish edge to the Fed

Stubborn inflation pressures in the US will encourage the Federal Reserve to back up its hawkish tone in commentary with action on policy rates. Headline inflation rose by 0.5% m/m in January, its fastest pace since October last year, and was up by 6.4% y/y, just marginally slower than the 6.5% recorded in December 2022. Core CPI also ticked barely lower in January, to 5.6% y/y from 5.7% a month earlier.

For the January CPI, energy costs rose by 2.0% m/m as gasoline and natural gas prices increased. Wholesale natural gas futures have declined in February from January levels so the impact of higher utility costs may prove short lived, though gasoline futures have been holding relatively stable. Our expectation for energy costs in 2023 is that they will rise over the course of the year which should add an upside edge to headline inflation.

In the core measure of inflation, shelter was the “dominant factor” in the increase according to the Bureau of Labor Statistics, rising by 0.7% m/m and showing little impact of the drop in housing costs that is underway in the US. Fed chair Jerome Powell said earlier this month that disinflation “had begun” but added that that is particularly prevalent in the goods sector. Non-food and energy goods prices ticked up by 0.1% m/m after three prior months of outright declines but price growth for goods is still comfortably below levels seen earlier in H1 2022 and for much of 2021. A measure of core services stripping out shelter dropped to 0.3% m/m in January, down from 0.4% a month earlier, and eased to an annualized rate of 3.2%. While encouraging, it will still take time to get to levels that the Fed would feel that it can ease back on a restrictive stance.

Several Fed speakers commented following the CPI print, all of whom raised and reiterated the prospect that rates would need to move higher to help get inflation back closer to targeted levels. Patrick Harker, head of the Philadelphia Fed, explicitly noted that rates would need to be above 5% though how far above would “depend a lot on what we’re seeing” while his counterpart at the New York Fed, John Williams, said that a rate of 5-5.5% at the end of year was “the appropriate framing.”

The so far hotter than expected data for the US—whether the inflation or jobs numbers—should unwind market expectations that the Fed will move toward an accommodative stance as early as H2 this year. Markets are still tentatively pricing in cuts in Q4 this year, likely anticipating that economic data will slow and force the Fed’s hand, but we now expect that the Fed will hike at the next two meetings (March and May) by 25bps before holding rates unchanged over the rest of the year. We had previously expected cuts before year-end but had noted that the risks to our rates view had been skewed to the upside. Provided that economic data does not materially collapse, we would still expect a hawkish bias to policy from the Fed this year.