The great news about inflation took a detour in January, as consumer prices came in hotter than expected in a development likely to quell any hopes for a cut in interest rates before late spring.
The closely watched consumer price index rose 0.3% last month, above forecasts for a 0.2% gain, while the annual rate fell only to 3.1% – above estimates of 2.9%. Increases in shelter costs accounted for more than two-thirds of the increase in the main index, according to the Labor Department’s Tuesday release. Food prices also increased, though energy costs fell.
Core prices, which exclude volatile food and energy components, rose 0.4% for the month, above estimates for a 0.3% gain, while the annual rate increased to 3.9% from 3.7% a year earlier. Still, that is considerably below where inflation was in 2022 and much of last year.
The January numbers will give the Federal Reserve a reason for concern, though, as the data suggests the stronger-than-expected economy may thwart plans for a cut in interest rates before the second half of 2024.
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Dow Jones Industrial Average futures fell more than 300 points after the news.
“We expect the Federal Reserve to cut interest rates two or three times in 2024, which is much less than the six rate cuts that the market expects,” said Skyler Weinand, chief investment officer at Regan Capital. “Even though inflation is decelerating, the Fed is concerned about easing too quickly given the potential for an unexpected second bout of inflation, which would hurt consumers in a meaningful way.”
Other measures have shown inflation moving closer to the Federal Reserve’s 2% target over recent months. Improved supply chains and a slower rise in gasoline, apartment rents and goods prices have helped.
Along with the health of the labor market, the Fed considers inflation among the key economic data points to watch as it looks to start cutting interest rates this year. The exact timing of when that will happen has changed as the economy has proved stronger than anticipated, and most economists now believe the first cut will not occur before the Fed’s May meeting.
“Robust job additions, higher than expected wage growth, and a rise in prices reported in recent manufacturing and services surveys have increased the odds of inflation being elevated for some time,” said Venkat Balakrishnan, head of asset allocation at MissionSquare Retirement. “If inflation comes in below expectation, the markets will cheer the welcome news that the economy and the job market can remain solid without increasing inflation. Conversely, if inflation comes in above expectation, the Fed may consider delaying the start of rate cuts for the year, prompting markets to calibrate accordingly.”
The resilience of the economy in the face of extremely tight monetary policy has surprised many, from Fed Chairman Jerome Powell to mainstream economists. In January, employers added 353,000 jobs, well above expectations, while a forecast of first-quarter gross domestic product from the Federal Reserve Bank of Atlanta sits at 3.4% annualized.
“We still have an economy that is growing reasonably well,” says Dan North, senior economist at Allianz Trade for North America, though he expects things to “drop off as the year goes on.”
In particular, interest rates that are at 40-year highs have failed to curb consumer borrowing, and that has led to Americans keeping up their spending habits. With the stock market posting record highs and housing prices also elevated, many people feel comfortable making purchases.
“Powell noted that the picture is unlikely to be clear enough by March to warrant a rate cut, which seems to be neutral for bond markets, but the prospect of ‘higher for longer, if appropriate’ will likely be taken as a negative by investors who would prefer to see rates fall.” said Melissa Brown, global head of applied research at SimCorp. “We believe rate cuts are likely later this year, and even if pushed out, it will be on the heels of a good economy.”
The government will report retail sales numbers for January on Thursday. Economists are expecting a slight decline after consumers spent freely in December. On Monday, retail fraud protection firm Signifyd said consumers spent 7% more online in January compared with a year earlier.
“The boost in online shopping follows a holiday season that shattered expectations and underscores several other rosy economic trends – gross domestic product is up, inflation is slowing, hiring is robust, interest rates are due for a cut and consumer confidence is rising,” Signifyd said.
On Friday, more inflation data will be released with the January producer price index – a measure of what businesses pay for the products and services they sell. The core index is expected to have declined to an annual rate of 1.7%. The PPI is often a predictor of future inflation as it shows prices that are early in the pipeline and often passed on to consumers.
Despite January’s surprise, the overall improving picture on inflation and a labor market that is not yet showing signs of buckling have made consumers happier than they have been in a long time. Also on Friday, the University of Michigan will release its preliminary February consumer sentiment number, expected to show a modest rise after January’s surge.