Inflation, measured by the headline CPI (Consumer Price Index) fell 0.1% in December versus November. That brought the annual headline inflation rate to 6.5%. That was exactly what a consensus of economists was looking for.
The core DPI, which strips out more volatile food and energy prices, rose by 0.3% in December from November. That brought the annual core inflation rate to 5.7%. Again, exactly what economists had forecast. (Remember, the inflation rate peaked at 9.1% this summer.)
The stock market didn’t know quite what to do with this inflation reading.
In the morning stocks were down on disappointment that the drop wasn’t bigger. That was a reasonable reaction since investors and traders had been pushing stocks higher over the last few days in anticipation of a bigger drop in the CPI inflation rate.
In the afternoon, investors and traders reconsidered and decided that the very slight decline in inflation in December would be enough to keep the Federal Reserve on track to raise interest rates by just 25 basis points, instead of 50, at the February 1 meeting of the bank’s Open Market Committee. And a smaller 25 basis point move would put the Fed on track to ending its interest rate increases after the Fed’s March 22 meeting.
The Standard & Poor’s 500 closed 0.34% higher and the Dow Jones Industrial Average ended up 0.64%. The NASDAQ Composite finished ahead by 0.61%. And the Russell 2000 small-cap index, closed higher by 1.74%.
You can see that consensus on when the Fed will stop in the odds calculated by the CME FedWatch tool from prices in the Fed Funds Futures market. Odds of just a 25 basis point increase at the February 1 meeting rose to 94.7% today from 76.7% yesterday. Odds of a 25 basis point increase at the March 22 meeting climbed to 76.5%. Two 25 basis-point increases would leave the Fed’s benchmark interest rate at 4.75% to 5.00%. That’s at the 5% level that the current market consensus sees as a peak for the Fed’s rate increases. The odds that the Fed will raise rates above 5% at the March 22 meeting are a low 4.2%, according to FedFunds futures prices.
Now remember that the CME FedWatch tool looks only at the expectations in the FedFunds Futures market. It’s a measure of current sentiment by traders and investors. Which means, of course, that these odds could be wildly wrong.
The fact that the market so strongly believes that the Fed will raise rates twice–by 25 basis points each time–and then say “All done” creates an opening for a really big negative surprise if the Fed decides to do something different.
I doubt that the Fed is happy that the financial markets have boxed it into this corner on rates, but the Fed is likely to be even less happy at the prospect of creating a large market drop by going against the consensus. I expect that Fed officials will spend the days before the quiet period that comes before the February 1 meeting trying to talk the market out of its complacency. I’d look for something in the February 1 statement from the Fed that tries to convince the market to weaken its belief in the two-and-done position. And for the central bank to resume trying to talk the market out of its conviction in the weeks before the March 22 meeting. (The March 22 meeting will, by the way, include the next DotPlot projections from the Fed on the future levels of inflation, interest rates, and GD”p growth revised from the December 14 projections.)
There were some “strange” elements in today’s CPI report. Housing prices, which should be among the most sensitive prices to changes in interest rates as higher mortgage rates presumably deter home buyers, rose 0.8% in December from November and are now up 7.5% year-over-year. (Shelter accounts for 30% of the headline CPI reading and 40% of the core figure.)
A sharp drop in gas prices more than offset the increase in housing costs, with gas at the pump dropping 9.4% in December after a 2% jump in November.
Food prices rose 0.3% in December from November. (Try telling that to anybody who has bought groceries lately or eaten at a fast-food restaurant.) Food prices had climbed by 0.5% in November.
