'I'm not sure we need 2% inflation': How investors are absorbing Tuesday's CPI report

By Vivien Lou Chen

Fed policy makers will release their updated interest-rate forecasts next Wednesday, which will give some indication of how they are interpreting the latest round of inflation readings

Investors and traders took February's hotter-than-expected consumer-price index report in stride on Wednesday, signaling a willingness to tolerate above-target inflation while waiting for a few more months of data to roll in.

Financial markets appeared calm, on the surface at least. Two- BX:TMUBMUSD02Y and 10-year Treasury yields BX:TMUBMUSD10Y ended only slightly higher for the third straight trading session, while fed-funds futures traded at levels that still imply the likeliest scenario is for the Federal Reserve to make a quarter-point rate cut by June. Stocks finished mixed just a day after the S&P 500 SPX had ended at a new all-time high of 5,175.27.A multitude of factors were at play in the thinking of many investors and traders, including an apparent acceptance of inflation that can remain above the Fed's 2% target as long as U.S. economic growth holds up. Another is a reluctance to budge from what the central bank indicated in December -that three quarter-point rate cuts will likely be appropriate in 2024. The current level of the fed-funds rate target is between 5.25%-5.5%."It does feel like the market reaction function has changed over the past few months, and investors are willing to tolerate slightly higher inflation data as long as that is being accompanied by strong growth," said Michael Reinking, a senior market strategist for the New York Stock Exchange, in a note on Tuesday. There are a number of moving parts to financial markets, however, and some traders are expressing lingering worries about inflation following Tuesday's CPI report. That data likely contributed to weak demand at a $39 billion auction of 10-year Treasury notes on the same day given renewed uncertainty about the trajectory of interest rates this year, according to strategist Will Compernolle of FHN Financial in New York. Fed policy makers will release their updated interest-rate forecasts next Wednesday, which will give some indication of how they are interpreting the latest round of inflation readings. That will put the spotlight on what's known as the median 2024 dot, the forecast for the level of the fed-funds rate that's likely to be appropriate by year-end.Meanwhile, the five-year break-even inflation rate, a measure of expected inflation, has been moving back up again since the start of this year in a sign of shifting, but unfavorable, dynamics.Tuesday's CPI report for February showed that the annual headline rate of inflation remained stuck at or above 3% for a ninth straight month. Even the more closely followed core rate, which is supposed to better reflect underlying trends, came in above expectations, at 0.4% on a monthly basis - pushing the year-over-year reading to 3.8%.January's CPI data also showed inflation speeding up, but that was seen as a temporary setback for Fed officials."The market is looking through the seasonal aspects of January and February inflation data," said Rob Daly, who oversees about $4.5 billion in fixed-income assets for Glenmede Investment Management in Philadelphia. "That said, maybe inflation has plateaued. The real question the market is asking is, 'If we still have strong economic growth, can we be OK with inflation that stays here, and at what point does the level of inflation become problematic?'"He continued: "Given that the labor market is tight, the economy is running well and corporate fundamentals are looking pretty good, I'm not sure we need 2% inflation. The market is humming along." The market and Fed alike have the benefit of waiting to see how inflation data for March, April and May will look before drawing any firm conclusions about a first rate cut in June, according to strategists at BMO Capital Markets.But this wait-and-see approach also risks catching many people off guard if price gains accelerate further from here, given inflation's propensity to move with speed, as it did during the run-up to its 9.1% peak in June 2022.The lack of convincing evidence that inflation is abating toward 2% "suggests the Fed may be on hold for much, much longer than the market expected," as Federal Open Market Committee members continue to wait for a clear-cut and well-established downward trend, said economists Lindsey Piegza and Lauren Henderson at Stifel, Nicolaus & Co. in Chicago.

While investors have pushed expectations for the first rate reduction out to June from March, "even this adjusted forecast may prove overly optimistic without ample improvement in the inflation data," they wrote in a note on Wednesday.

-Vivien Lou Chen

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03-13-24 1606ET

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