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The Fed just made this number a lot more important

The Fed dialed back forecasts for how fast it will raise rates over the next couple of years, so now anything to do with inflation becomes more important to markets, as a flare up in prices or expectations might be the one thing that could get the Fed moving.

The consumer price index, expected at 8:30 a.m. EDT on Thursday, is the first fresh inflation report after the Fed forecasts Wednesday revealed that one rate hike is probably more likely than two this year. Fed forecasts also show at least four fewer hikes than previously forecast through 2018.

Janet Yellen chair of the U.S. Federal Reserve
Alex Wong | Getty Images
Janet Yellen chair of the U.S. Federal Reserve

Economists expect May CPI to be tame, rising by 0.3 percent, or 1.1 percent year over year, when it is reported at 8:30 a.m. EDT, according to Thomson Reuters. That compares to 0.4 percent in April. The core is expected to be up 0.2 percent or 2.2 percent year over year, about the same as last month.

The Fed on Wednesday did not make much change in its message and it emphasized it will still hike rates, but now seemingly more slowly. The message of a slower-moving Fed was clear in the so-called "dot plot," a chart with dots on a timeline representing each Fed official's interview. The Fed did retain its forecast for two rates this year, but the dots revealed that six members want to see one hike this year, up from one in March.

"The extent to which the dovishness that's been communicated by the dots is really what the key is. You have about six people thinking one hike is appropriate [for 2016]," said Jim Caron, fixed income portfolio manager at Morgan Stanley Investment Management. "That's a little bit of a surprise. The other surprise is if you look at 2017 and 2018 … they're taking out one hike in 2017 and they're taking out two and a half in 2018. It calls into question how do they get to the 3 percent. Is that just pie-in-the sky stuff and do they take that down to 2 percent?" Three percent is the terminal rate, or neutral rate.

"Just a few weeks ago, the expression 'gradual normalization' meant a rate hike every six months, and now it looks like a rate hike every year. It's a very muddled picture and they have not helped it," said Ward McCarthy, chief financial economist at Jefferies.

McCarthy said it's less clear what will now trigger Fed rate hikes, and even inflation may not matter. The Fed was expected to hold off on June and possibly July after May's very weak employment report showed just 38,000 jobs created. The fact that Brexit — the U.K. vote on whether to stay in the European Union — has created some concern in markets was seen as another factor, but less so.

But some Fed watchers are wondering why the Fed is shifting so much of its longer-term view on rates.

"There was an abrupt change from the minutes of the April meeting to what they did today. What would get you from point A to point B? The only major important difference is maybe the labor market weakened, but as she said, you shouldn't base too much on one data point. She didn't offer much different except for that one data point," said McCarthy.

Art Cashin, director of floor operations at UBS, said stocks reacted late in the day to comments from Yellen as she was asked about the fact that the meeting minutes indicated Fed members had wanted to hike rates in June. Cashin said there was also more than $1 billion in stock for sale going into the closing bell, and that weighed on the market. The S&P 500 closed at 2,071, off three points.

The big moves in markets after the Fed meeting were in Treasury yields where the two-year note went from a yield of about 0.72 percent to 0.66 percent late in the day. The 10-year was at 1.57 percent. Treasury yields have been slipping in recent weeks due to the easing programs of other central banks and worries about Brexit.

Caron said he continues to see just one rate hike in December. "The Fed is out of play for a while. This should be good for other assets. This should be good for EM. This should be good for high yield. ... We have to get Brexit out of the way before the all-clear siren sounds. This should be a very risk-on outcome to this meeting, except that there's a risk event that sits in front of us," he said. The Brexit vote is June 23, and Fed Chair Janet Yellen confirmed at her press briefing that the Fed did consider it during the meeting.

The Fed's statement did comment that household spending was improving, but that labor market improvement was slowing.

Scott Clemons, Chief Investment Strategist at Brown Brothers Harriman, said he is watching inflation but the single most important data he is watching is the average hourly earnings growth, at about 2.5 percent. "That may be the source of inflation pressure that forces the Fed's hand, but not yet. Wages are beginning to outpace core prices," he said.

Core CPI has been above the Fed's 2 percent target, but the Fed's preferred inflation measure is the PCE deflator, and it is below 2 percent.

Clemons said the Fed's change in interest rate forecasts is not a surprise. "I think the consensus has been moving that way for some time. You have one more rate hike [this year], and then it just becomes a guessing game," he said.

But McCarthy said what seems to be an about-face by the Fed in its longer-term view is bad for confidence.

"They shatter confidence. What comes across is they're not confident in the economy and they're not confident in monetary policy, and that's not a good thing from a central bank," said McCarthy.

Besides CPI, weekly jobless claims are also reported at 8:30 a.m. EDT and are expected to rise slightly to 270,000. The current account is also reported at 8:30 a.m., and the Philadelphia Fed survey is released at 10 a.m.

Caron said he was also watching the Bank of Japan overnight, which he said has a 50 percent chance of surprising the market after its meeting.

Amherst Pierpont chief economist Stephen Stanley expects to see a 0.3 percent increase in CPI, and 0.2 percent in core. "A noticeable seasonally adjusted rise in energy prices drives the headline estimate, while my core forecast reflects a largely trend-like performance. Core services prices have firmed slightly and will continue to drive the aggregate, led by shelter costs. Over time, core goods prices are likely to stabilize or tick up in the wake of the turnaround in import prices in recent months, but it is likely too early to see that effect by May," he wrote.