Fed expected to hit brakes on big rate hikes next meeting after CPI dip

A larger-than-expected slowdown in consumer inflation last month will likely let the Federal Reserve pare its rate increases as the impact of its monetary tightening may finally be showing up in the pace of price increases.

October data published Thursday by the Labor Department showed key items like rents increasing less than expected, while the price index for used cars — a culprit in the initial, pandemic-related surge in inflation — declined by 2.4%, the fourth monthly drop.

Though inflation remained high by historical standards, with prices increasing 7.7% from a year earlier, the monthly pace of “core” inflation that excludes volatile food and energy dropped by half, to 0.3% in October from 0.6% the month before.

That step-down sent US stocks soaring. In the Treasuries market, the yield on the 2-year note, the maturity most sensitive to Fed rate expectations, dropped by nearly 20 basis points, the most in one day since June.

And traders in futures contracts tied to the Fed’s benchmark rate show traders now expect the blistering pace of policy tightening to slow next month.

After raising rates more sharply this year than at any time since the 1980s, including four straight 75-basis-point rate hikes that brought the policy rate to a range of 3.75% to 4% as of last week, the Fed is seen shifting to a half-point rate hike next month and quarter-point hikes after that.

Rate futures contracts are pricing in a top policy rate in the 4.75% to 5% range next March — lower than the 5%-plus range seen before the report — and interest rate cuts in the second half of the year. Fed policymakers were quick to point out that their work is far from done.

“This morning’s CPI data were a welcome relief, but there is still a long way to go,” new Dallas Fed President Lorie Logan said. 

Still, she said, the current state of the economy can be summed up in just five words: Inflation is much too high.

“While I believe it may soon be appropriate to slow the pace of rate increases so we can better assess how financial and economic conditions are evolving, I also believe a slower pace should not be taken to represent easier policy.”

Fed officials have said they wanted convincing evidence that inflation was in decline before altering their approach, and still believe returning inflation to their 2% target will require keeping rates at a “restrictive” level for a potentially extended period of time.

Continued high inflation for services, possibly reflecting labor markets that remain tight, could prevent any quick resolution of the overall inflation problem.

But the central bank at its last meeting also indicated it could take a step back from delivering interest rate hikes in such large chunks, and might take a more tempered approach as the economy adjusts to the “lagged” impact of monetary policy.

Thursday’s report suggests those effects may now be kicking in.

“The hikes in interest rates are beginning to bite into the economy and lower inflation as consumers become more frugal,” said Peter Cardillo, chief market economist at Spartan Capital Securities.

Speaking after the report, Philadelphia Fed President Patrick Harker indicated his support for slowing rate hikes and then stopping, perhaps even earlier than markets are now pricing in.

“I am in the camp of wanting to get to what would clearly be a restrictive stance (with the policy rate) somewhere north of four-ish, you know, four and a half percent, and then I would be okay with taking a brief pause, seeing how things are moving,” he said.