Fed Meeting: Soft CPI sets the stage for a hawkish surprise

Weak CPI inflation data released on Tuesday may have thrown investors a curveball ahead of today’s Fed meeting. The S&P 500 initially rallied on the data as markets posted a low peak for the Federal Reserve’s key interest rate.

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However, there is good reason to suspect that Fed Chair Jerome Powell will be affected by tamer readings of the CPI and core CPI inflation. In fact, Powell gave a speech on November 30 explaining why these inflation rates are wrong for the Fed.

There is no doubt that the Fed will give up its strolling pace today, with a half-point increase. This would raise the federal funds rate to a range of 4.25% to 4.5%.

Fed meeting to clarify interest rate hike expectations

But the November CPI report, which showed inflation falling to 7.1% from 7.7%, may have shifted expectations too far for the next Fed meeting and for the peak rate of the cycle.

After core CPI rose just 0.2% from October, markets are factoring in a 62% chance that the Fed will hike just 25 basis points on February 1st. But Powell will probably use his press conference at 2:30pm to hint at another half-point hike, barring unexpected developments, such as a shift in job gains into job losses.

Along with the 2 p.m. ET policy statement, the Fed will also release a quarterly economic outlook, including interest rate forecasts. At the September meeting, policymakers set the rate to peak at 4.6% in 2023. Markets now see the Fed’s key rate peaking at 4.9% in May, down from about 5.05% before the CPI report, according to FedWatch Group’s Facebook page. CME.

However, today’s Fed projections may show that the federal funds rate is just over 5% through the end of next year.

If the Fed’s guidance proves to be more hawkish than markets expect, it probably won’t bruise the S&P 500 so badly in stock market action on Wednesday. With lower inflation, the markets can still be in a celebratory mood.

However, Powell is likely to demonstrate, as he did last month, to keep interest rates higher for longer, shifting the focus from CPI to wage growth. This will likely keep a lid on the current rally.

The Fed’s new headline inflation rate

The specific inflation rate that Powell says the Fed and Wall Street should focus on comes from the Commerce Department’s Personal Income and Personal Spending report, which tracks personal consumption expenditures, or personal consumption expenditures.

Powell’s new favorite inflation rate also happens to be the most problematic for the S&P 500. The measure factors in commodity inflation, which is declining rapidly. It also excludes housing inflation, which appears set to decline in 2023 as government data catches up with stalled growth in market rents.

That leaves only essential services other than housing, such as health care, education, hospitality, and haircuts. Because changes in the prices of such services correlate so closely with wage growth, Powell said, they provide the best indication of where core inflation is headed.

The Fed’s new flagship inflation rate is not good for the S&P 500 because it focuses on the strongest part of the economy: the tight labor market. Until the job market breaks, wage growth is likely to remain stubbornly high, and the Federal Reserve may raise the benchmark interest rate higher and for longer than markets expect.

The Consumer Price Index report showed that prices for basic services, excluding shelter, were flat in November compared to the previous month. But a comparable PCE would not be so tame. This is partly because the two indices measure health care inflation in much different ways, with the measure of personal consumption expenditures more reflective of wage pressures. The Medicare Services CPI fell 0.7% in November, the largest monthly drop on record.

The S&P 500 is near a key level

S&P 500 futures rose 0.4% early Wednesday in stock market action, following Tuesday’s gain of 0.7%. The S&P 500 rose nearly 3% at a morning high after the consumer price index eased. But investors probably didn’t want to get the wrong side of the hawkish Fed meeting.

The Dow Jones Industrial Average rose 0.4%, while the Nasdaq Composite rose 0.1%.

The S&P 500 crossed the 200-day line during the day on Tuesday, before closing below a key technical level. The previous several rally attempts through April were stalled at the 200-day moving average.

All major indices hit resistance at the December 1 high on Tuesday.

During Tuesday’s close, the S&P 500 rose 10% from the bear market’s closing low on Oct. 12. However, the S&P 500 is still 18% below its January 3 high. The Dow Jones has gained 16.5% since bottoming out, leaving it just 9% below its all-time high. The Nasdaq rebounded by 6.6% but remained below its peak of 31.5%.

Be sure to read IBD’s Big Picture column after each trading day for the latest information on the prevailing stock market trend and what that means for your trading decisions.

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