Inflation Report Increases Bets for More Aggressive Rate Hikes from the Fed

Investing.com – A fairly strong inflation report released on Wednesday pushed up market expectations that the Federal Reserve could accelerate plans to remove accommodative monetary policy this year.

The consumer price index (CPI) for January increased by 0.5% from the prior month, beating expectations for a gain of just 0.3%.

Annual headline inflation held steady at growth of 2.1%, surprising the consensus that had expected a drop to 1.9%.

Core CPI, which excludes volatile food and energy costs, rose by 0.3%, edging past expectations for 0.2% increase. That was also its largest increase since January 2017.

Annual core inflation also unexpectedly held steady at 1.8% when analysts had forecast a slight decrease to 1.7%.

Markets reacted quickly with an immediate increase in the odds for a more aggressive tightening of monetary policy.

Although the bets for the next rate hike by the Fed in March held steady at 81.7%, according to Investing.com’s Fed Rate Monitor Tool, markets increased the probability for three hikes this year to 58.7%, from 54.3% prior to the release. Notably, odds for a fourth hike in December advanced to 23.2%, compared to 19.5% ahead of the publication.

Furthermore, U.S. futures tanked directly after the data and Wall Street later opened in negative territory.

The dollar also reacted to the increased expecatations for policy tightening by hitting intraday highs against major rivals at 90.02, while the yield on the 10-year U.S. Treasury also spiked to session highs of 2.882% on the back of higher inflation expectations.

Following the release, ING chief international economist James Knightley admitted that the Fed could accelerate plans to tighten policy.

"In an environment of strong consumer demand, corporates have the pricing power to pass on higher costs to customers, which is going to be increasingly significant given the prospect of a pick-up in wage growth," he said in a note following the release.

Knightley added that he expected core inflation to be back above the Fed's 2% target in March with headline inflation breaching 3% by this summer.

"In turn, this healthy growth, rising inflation environment means that we consider there to be upside risk for our call of three Fed rate hikes in 2018," he concluded.

Rafiki Capital head of research and strategy Steven Englander played down the implications of the data, but admitted that they implied that a different inflation regime than before was coming into play.

“The last ten years was below target inflation and now the expectations are adjusting upwards, which means the Fed is not as friendly,” he commented.

“It doesn't mean that equities should collapse, but what it does mean is the days of sub-10 on the VIX are done and it should settle closer to historical norms of 13 or 15,” Englander concluded.

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