After a Hot January Inflation Report, Will the Fed Wait Longer to Cut Rates?

As inflation readings came in above expectations in the January Consumer Price Index report, investors are once again rethinking when the Federal Reserve may cut interest rates. Ahead of the report, thanks to February’s strong employment numbers, bond traders had already pushed back the time they anticipated cuts would start, from March to May. With this hotter-than-forecast inflation report, the bond market now sees the first cut coming in June.

The Bureau of Labor Statistics reported that the Consumer Price Index rose 3.1% on an annual basis and 0.3% on a monthly basis in January. Both figures were higher than in December, and the annual figure was higher than economists’ expectations of 2.9%. The BLS said more than two-thirds of the monthly increase was attributable to rising shelter costs. Core CPI, which excludes volatile food and energy prices, rose 3.9% on an annual basis and 0.4% on a monthly basis. Both readings were higher than economists predicted.

“Today’s report showed inflation higher than expected,” says Preston Caldwell, Morningstar’s chief U.S. economist, “but there’s no reason to panic.”

Caldwell still sees a May rate cut as “highly likely,” and points out that shelter and healthcare costs will have a smaller impact on the Personal Consumption Expenditures report—the Fed’s preferred inflation gauge—than on the CPI report.

January CPI Report Key Stats

• CPI increased 0.3% for the month after rising 0.2% in December.
• Core CPI rose 0.4% after growing by 0.3% in December.
• CPI rose 3.1% year over year after increasing by 3.4% the prior month.
• Core CPI increased 3.9% from year-ago levels after increasing 3.9% in December.

Caldwell notes that on a three-month annualized basis, the inflation rate came in at 2.8% in January, thanks to a 10% drop in energy prices. The core inflation rate, on the other hand, was 4.8%. Core inflation, which excludes volatile food and energy prices, has been much stickier than headline inflation.

Sticky Shelter Inflation Continues

“Shelter (mostly housing) was the chief culprit for January’s upward inflation surprise,” Caldwell says, “Likewise, it’s been almost solely responsible for inflation’s staying power over the last several months.” According to him, excluding shelter costs, core CPI was just 2.3% annualized over the past three months.

“Leading edge data continues to strongly indicate that an eventual normalization of housing inflation is inevitable,” Caldwell adds, “even while the timing is somewhat uncertain.” Outside of housing costs, Caldwell notes that a jump in healthcare inflation has also been pushing CPI readings higher.

When Will the Fed Cut Rates?

Over the past few months, bond futures traders have continually recalibrated their expectations around Fed rate cuts. “It’s true that a March rate cut ... is now essentially ruled out,” Caldwell says.

As of noon EST Tuesday, traders saw a 35.3% chance of a quarter-point rate cut at the central bank’s May meeting, according to the CME FedWatch Tool. This is up from 17% a month ago. Expectations for a March cut have evaporated from more than 75.0% last month to 8.5% today.

Caldwell characterizes the bond market’s strong response to the inflation data as an overreaction, in large part because of the differences in the way PCI and PCE inflation are calculated. The distinction comes from how the PCE index incorporates recent increases in shelter and healthcare prices. He says core PCE inflation—the Fed’s preferred measure of whether inflation has reached its 2% target—was just 1.5% in the three months ending in December.

“We think core PCE inflation will remain favorable in coming months (showing a downtrend in terms of the year-over-year numbers), which will push the Fed to cut in May,” Caldwell explains.