Bumpy road ahead: Hot inflation data stalls the Fed’s rate cut plans

The path to disinflation: A bumpy ride

Minutes from the March Federal Open Market Committee (FOMC) meeting released last Wednesday afternoon showed that officials are concerned inflation isn’t cooling quickly enough. Given this year’s economic indicators “pointing to strong economic momentum and disappointing readings on inflation,” officials need “greater confidence” that inflation is “moving sustainably” toward its 2.00% target. While officials reasoned that the policy rate is “likely at its peak for this tightening cycle,” it remains unclear when it will be appropriate to start cutting rates this year. Regardless of if or when, officials acknowledged at the meeting that they expect the disinflation process to be “somewhat uneven” or as Federal Reserve Board Chair Jerome Powell has called it, a “sometimes bumpy road.”

Markets go wild on hot inflation data

The hot inflation reading from the March Consumer Price Index (CPI) report last Wednesday morning adds another bump in the path to Fed monetary policy. The March CPI beat expectations (3.70%), rising 3.50% from a year earlier and up from 3.20% in February. Core CPI also rose more than expected to 3.80%, which was unchanged from the February reading. Core CPI exceeded expectations for the past three months, but inflation is not tied to just one component across the board. Rather, it is tied to a combination of different contributors. While shelter continues to be a major contributor to inflation, March saw a significant increase in transportation services (notably car insurance and car repair) and other personal services. Due to the inconsistency in key drivers, the market reset its expectations for inflation this year.

While the rise in CPI may not appear monumental compared to expectations, it sent the market reeling. The 10-year Treasury yield rose by 18 basis points, topping 4.50%, which is the highest reading since November 2023. The two-year Treasury, which is especially sensitive to near-term interest rate policy, soared 23 basis points. The dollar also strengthened in response, rising about 2.00% on average against every major currency. By Thursday morning, the Dollar Index reached 105.3, the highest reading since mid-November. Inversely, the Japanese yen fell to its weakest level since 1990, with USD-JPY surpassing 152 yen — a level at which traders historically have seen the Bank of Japan intervene.

Due to the hot inflation data reading, the market reevaluated its expectations for future interest rate policy. Prior to the CPI release, the market expected three cuts, with the first occurring in June. This was in line with the Fed’s dot plot projections released in the March meeting. Now, the market appears more hawkish than the Fed; markets are only pricing in two rate cuts this year, with the first cut occurring in September, followed by the possibility of another rate cut in December. Some economists, however, are weary of any rate cuts this year, especially as dates for FOMC meetings with expectations for rate cuts bleed into the U.S. presidential election this November. The election and geopolitical turmoil, coupled with stickier inflation readings and rising energy prices, only complicate Fed decision-making.

A closer look at the forward curve

The change in the market’s rate predictions of the Fed’s interest rate policy decisions can be seen in the shift in the one-month Term SOFR forward curve from Monday to Friday of last week. Now, two 25-basis-point cuts are being priced into the curve, opposed to three. The curve illustrates that the market is expecting “higher for longer” rates. By the end of last week, the forward curve had shifted an average of 16 basis points over the next six years compared to the start of last week. Swap rates soared about 20 basis points on Wednesday and remained at almost the same levels by the end of the week.

Corporates should be cognizant of the market’s continued shift in long-term expectations and think more medium- to long-term regarding interest rate hedging. If there’s something to be gleaned from the past year, it’s that anything can happen.

The week ahead

This week, Fed Presidents of Dallas, San Francisco, Cleveland, New York, Atlanta, and Chicago will be speaking. Markets will listen closely to get perspective on the reassessment of the Fed’s policy given last week’s hot inflation reading. There will be other notable economic releases including U.S. retail sales on Monday, housing starts on Tuesday, and U.S. leading economic indicators on Thursday. In light of Iran's attack on Israel over the weekend, market participants will continue to weigh its impacts on the global economy. As of Monday morning, the market is now only pricing in one rate cut by the end of the year.