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As inflation trends higher, markets await the response from a changing Fed

News that consumer prices rose higher than expected in January will put pressure on the Federal Reserve to get out ahead of inflation with rate hikes and possibly a faster reduction of its balance sheet faster than previously anticipated, economists said.

The consumer price index rose 2.1% on an annual basis in January for the second month in a row, while core CPI, which excludes food and energy, was up 1.8%, the same as in December, according to Department of Labor data released Feb. 14. Consensus expectations had been for headline CPI to moderate to 1.9% and core CPI to drop to 1.7%, Jefferies analysts said in a research note.

"We're seeing strength across the board," said Joseph Song, senior U.S. economist at Bank of America Merrill Lynch. "Core goods were up, apparel prices jumped, core services stayed on trend all those things help keep inflation trending higher."

As investors took stock of the new consumer data, U.S. equities markets, which had opened down, had recovered by midday trading in New York, with the S&P 500 Index up 0.40% and the Nasdaq Composite Index up 0.91%. Yields on the 10-year Treasury rose to 2.896% after inflation data was released, the highest seen in the past 12 months. Bond yields rise as prices fall.

Inflation expectations

Though a few data points cannot guarantee the Fed's next moves, the growth in CPI, coming on top of strong January wage growth, is now part of a trend that has persisted for the past month, said Kristina Hooper, global markets strategist at Invesco.

"The Fed will look for more confirmation, but now we're seeing inflation trending higher," she said.

"It stands to reason when you get such a late-cycle stimulus like you did with the tax reform package," Hooper added, referring to tax changes enacted at the end of 2017 that cut the corporate rate to 21%.

Tax cuts, wage growth, plus a continued strong economy overall also makes companies more confident that they can pass on costs to consumers, said Sarah House, economist with Wells Fargo Securities.

"Before, companies took a hit on their margins," she said. "But now that they're seeing more strength out of core inflation, businesses feel they have more pricing power."

January retail sales figures came in below expectations, however, which could give the Fed pause as it is considering its next rate hikes. "Higher inflation and lower consumer demand this is a double whammy for equities," Song said.

Fed changes

Besides inflationary pressure, the changing membership of the Federal Open Market Committee also creates some uncertainty, Hooper noted. The new Fed chair, Jerome Powell, is viewed as an "ideological twin" to former Fed chair Janet Yellen, but Hooper said there is evidence he could approach Fed policy differently, especially when it comes to how fast the central bank will move to reduce its $4.5 trillion balance sheet, a process it began last year.

FOMC minutes from 2012 revealed that Powell was reluctant to go along with a third round of quantitative easing, which could mean he would want to deleverage faster, if inflation continues to rise.

"We'll get a good sense of him from his Humphrey-Hawkins testimony at the end of February," Hooper said, referring to the Fed president's semiannual appearance before Congress.

Until then, "expect a lot of volatility, a lot of noise [in markets] as we work through all these changes and dynamics," she said.