Fed May Hike 50bp Considering the Persistent Inflation

Due to persistent inflation, the Fed is expected to adopt a more hawkish stance, leading to a 50-basis point increase in March and subsequent hikes of 25 basis points in both May and June.

Week in a Nutshell

Resurging inflation leads to my revised forecast of a 50bp rate hike in March and a higher terminal rate

Recent inflation data indicates that the underlying inflation trend may have halted its moderation in the past few months. Despite the Fed's decision to slow down rate hikes to 25 basis point increments in February, the persistent inflation, coupled with favorable labor markets and easy financial conditions, suggests that the Fed will not rely on goods-led disinflation, as it may only be temporary. Moreover, there is a likelihood of a resurgence in underlying trend inflation, posing the risk of under-tightening. Therefore, aggressive policy measures may be necessary to tighten financial conditions. In light of these developments, we have revised our Fed prediction for the near-term as follows.

• A 50bp rate hike in March. Two 25bp rate hikes in May and June to a terminal rate of 5.50-5.75%. Previously, I had expected one more 25bp rate hike in March to a terminal rate of 4.75-5.00%.
• My expectation for the first cut is unchanged at March 2024.
• I maintain my view that balance sheet reduction will continue until March 2024.

FedSpeak and the February minutes strike hawkish tone

Overall, I interpret the February FOMC minutes as being hawkish.

It was surprising to note that more participants than expected favored a 50 basis point hike, and this number could be increasing following strong January nonfarm payrolls and core PCE inflation data. Furthermore, the statement in the minutes suggesting that easing financial conditions could prompt a higher terminal rate was also hawkish. The lack of discussion in the minutes on the Fed's criteria for pausing rate hikes could imply that the Fed is moving away from ending the current hiking cycle in response to recent data, despite Chair Powell hinting at the possibility of such discussions.

Although Fedspeak has been somewhat mixed, incoming price data and my hawkish interpretation of the minutes suggest that there could be more rate hikes in the future. Boston Fed President Collins, who I had previously considered to be dovish, has now adopted a more hawkish stance, indicating that she expects further rate increases to reach a sufficiently restrictive level and hold there for an extended period of time. She also mentioned the possibility of preemptive policy action to avoid the risks of under-tightening and runaway inflation. This suggests that she might support more aggressive actions to control inflation. On the other hand, St. Louis Fed President Bullard, who is usually more hawkish, reiterated his preference for a terminal rate of 5.375%, which I found surprising given the strength of incoming data. It is possible that he and Cleveland Fed President Mester are comfortable with recent market pricing of more rate hikes and might not see the need to further control market expectations.

Strong incoming price data maintains pressure on Fed

The January core PCE inflation rate has increased more than expected, putting pressure on the Fed to implement further rate hikes. Additionally, strong consumer and industry data suggest that the economy's underlying momentum may be stronger than previously thought. In January, core PCE inflation accelerated to 0.571% from a revised 0.374% in December. The contribution from core goods prices to m-o-m core PCE inflation turned positive in January, and non-housing core service PCE inflation also accelerated to 0.58% m-o-m. These inflation data may push the Fed towards more hawkish policy.

Incoming data suggests a positive outlook for consumers, with January personal spending and income increasing, likely due to temporary idiosyncratic factors. However, there are concerns about the impact of inflation on wage growth, as year-ahead inflation expectations increased to 4.1%.

Flash S&P Manufacturing and Services PMIs both accelerated in February, suggesting that the underlying economic momentum may be stronger than previously thought. However, existing home sales fell in January, and building permits and housing starts released the previous week were weak, suggesting that the underlying state of the housing sector remains weak despite strong new home sales.

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