Markets react to the last CPI and PPI reports before the next Fed meeting

Interest rate markets

Last week saw two updates on the Fed’s progress in battling inflation with the CPI and PPI reports. On Thursday, CPI surprised markets by coming in higher than expected at 3.40% year-over-year. Month-over-month CPI was up from the 0.20% reading in November to 0.30% in December, with shelter continuing to be a thorn in the Fed’s side as it rose 0.50% month-over-month. Core CPI rose among the thorny headlines as month-over-month core CPI met expectations at 0.30%. Despite the tick-up, rates closed lower on Thursday, showing that the market’s faith in Fed control over inflation can withstand a little fair weather on the way back to the two percent inflation mandate.

On Friday, the market’s trust and patience was rewarded when December’s U.S. Producer Price Index, often viewed as a leading inflation indicator, fell month-over-month by 0.10% and was up 1.00% year-over-year. These will be the last inflation reports, aside from the Fed’s preferred Core PCE Price Index, ahead of their next meeting at the end of the month. The market was largely unfazed, still pricing around six rate cuts by the end of 2024.

Federal Reserve of New York President John Williams commented on the market’s predictions Wednesday, saying that he believes it is too soon to cut rates. He mentioned that the Fed will likely need to hold rates at this level for some time until the economy is sufficiently cool and continues to shrink the Fed’s balance sheet in tandem. If the Fed’s stated intentions to keep rates elevated are to be trusted, it would provide organizations an opportunity to fix their interest rates with a hedge while the forward curve still has an ambitious rate cut schedule priced in.

When looking at the Beveridge curve (a useful visualization of the labor market through different economic cycles), it demonstrates the Fed’s effectiveness in helping to cool the economy without having a major impact on unemployment. Even though the vacancy rate has come down, there is still more room to fall until it is closer to historical norms. Until unemployment starts to climb or liquidity dries up, the Fed has little incentive to cut rates until inflation is much closer to their 2.00% mandate.

Commodity markets

Over in the Middle East, the U.S. and the U.K. jointly carried out airstrikes in Yemen in response to continued attacks by Houthis on cargo ships in the Red Sea. Despite the continued escalation, Brent prices have remained in the high 70s as cargo traffic through the area has not yet been meaningfully impacted. These prices are still significantly down from September’s highs, as concerns of over supply are still on the forefront of trader’s minds. This was echoed last Monday when Saudi Arabia announced they will cut the price of oil sold to Asia to keep in line with expected prices.

The week ahead

In the shortened holiday week, we can expect an update on European inflation with CPI reports from the E.U., U.K., and Germany. On Wednesday, we will get an update on the American consumer with December’s monthly retail sales.