Fed's rate-hike warnings snubbed by markets rising on disinflation outlook

The Federal Reserve's most aggressive monetary policy shift in decades is likely to continue through the spring, with rate cuts highly doubtful until sometime in 2024. Financial markets, however, see a light at the end of the tunnel.

On Feb. 1, the central bank increased its benchmark federal funds rate by 25 basis points, and Fed Chairman Jerome Powell indicated that more hikes were coming as the Fed's battle against persistently high inflation was far from over. The Fed has now increased rates by 450 basis points since March, raising the federal funds rate to a level not seen since late 2007.

In spite of the ongoing hikes, markets continued to rally as Powell held his post-meeting press conference, even as he stressed that the Fed was "strongly committed" and "strongly resolved" in its policy fight against inflation and ruled out even the thought of rate cuts this year.

"It would be very premature to declare victory or think that we've really got this," Powell told reporters.

Market rally

The S&P 500 settled up 1% on the day and has risen 7.7% since the start of 2023. The yield on the U.S. Treasury 10-year bond, which moves opposite prices, closed at 3.39% on Feb. 1, down 13 basis points from a day earlier and down 40 basis points from the start of the year.

"Markets could feel encouraged by the fact that we're one step closer to defeating inflation," said Callie Cox, a U.S. investment analyst at eToro. "Powell also expressed more of a willingness to be data-dependent and flexible, which has been music to the market's ears."

While Powell repeated the central bank's commitment to "stay the course until the job is done," and said the Fed needed "substantially more evidence" that inflation was on a real downward path, markets keyed in on the chairman's comments that there has been some progress in bringing inflation down without weakening the labor market.

"It is gratifying to see the disinflationary process now getting underway," Powell said.

Tone shift

The chairman also seemed to brush off concerns of the ongoing rally in financial markets, claiming that short-term moves had little bearing on the Fed's policy path forward.

"This was a shift in tone," said Josh Jamner, an investment strategy analyst at ClearBridge Investments, pointing out that this week's press conference was a stark departure from Powell's "fire and brimstone" speech in Jackson Hole, Wyo. in August where he warned of "pain" from the Fed's policy tightening.

The full brunt of the Fed's ongoing rate hike push has yet to be felt throughout the economy, but GDP growth, consumer spending and business investment are all slowing, the housing market has been chilled by higher mortgage rates, and goods prices have fallen, Powell pointed out Feb. 1.

"The fear of inflation, from the Fed's position, has just started to come down," said Patrick Leary, a senior trader with Loop Capital Markets.

Powell repeated concerns from the Fed's December meeting that while overall inflation, particularly inflation on goods, appears to be in decline, services inflation has yet to be curbed.

The year-over-year increase of the consumer price index, the market's preferred inflation metric, has fallen from a peak of 9.1% in June to 6.5% in December. Still, services inflation minus shelter has increased over that time.

Services are heavily influenced by wages, which will likely remain elevated as unfilled jobs continue to significantly outpace the number of Americans seeking work.

Labor market imbalance

There were over 11 million open jobs in the U.S. in December, about 554,000 more than there were in November, the Bureau of Labor Statistics reported Feb. 1. In December, there were nearly two available jobs for every unemployed worker in the U.S., the data shows.

If employers need to continue to raise wages in order to fill these open positions, services inflation could remain high, prolonging the Fed's push for higher rates.

The employment cost index, a broad measure of labor costs, rose just 1% in the December 2022 quarter, the smallest increase in a year, as growth in wages and salaries and benefits all slowed, the Bureau of Labor Statistics reported Jan. 31.

Powell said the labor market remains out of balance, though the resilience in the jobs market to rate hikes may be a sign that a recession could be avoided.

With the January jobs data to be released Feb. 3 and the February data to be released before the Fed's March meeting, along with two additional inflation reports, the outlook on the Fed's rate path, both within the central bank and from markets, could shift markedly.

"The market can sometimes get ahead of itself," said Jamner with ClearBridge. "The market has, at times, led the Fed and, at times, the Fed has led the market."

For now, it appears the Fed is sticking to its guns, digging in on additional rate hikes toward a 5% federal funds rate, while letting the markets hold on to hope that some policy easing could be near.

"Deep down, investors just want to make sure the Fed has this situation under control," said Cox with eToro. "And so far, the Fed hasn't lost control."