Market Insider

Goldman, JPMorgan boost rate hike expectations on hotter inflation

Zandi: I would hike in March, but FOMC might not

Consumer spending and inflation data shifted into a higher gear in January, signaling the potential for an earlier-than-expected Fed interest rate hike, if the trend continues.

Fed Chair Janet Yellen pushed up the odds of a March hike with her hawkish comments Tuesday during her Senate testimony, but the strength of Wednesday's retail sales and hotter-than-forecast CPI inflation data nudged them even higher — to about 30 percent.

JPMorgan economists, in fact, changed their forecast for a June rate hike to May based on the two economic reports.

"We still think March is too early for them to hike, particularly given their propensity to prepare markets for a move. Instead, we think March would be a good meeting for them to prepare the markets for a hike at the subsequent meeting on May third," the economists wrote. Most Fed watchers have forecast a June rate hike.

Goldman Sachs economists also said that based mostly on the hotter inflation reading, the likelihood of a March hike increased to 30 percent from 20 percent, but they also see a better chance for May.

"In short, we now think it is a close call whether the committee will hike the funds rate at the next two meetings or wait until June, and we see very high odds [90 percent] of at least one rate increase by mid-year," they wrote in a note.

The Consumer Price Index jumped 0.6 percent in January, after rising 0.3 percent in December, for its biggest monthly gain in four years. The CPI was up 2.5 percent, in the largest year-over-year gain since March 2012. It rose above 2 percent for the first time in two years in December.

"Up to this point, inflation had been creeping higher, but the pace is clearly accelerating. The acceleration in the inflation picture along with the continued strong performance of the consumer sector opens the door and increases the probability that the Fed will raise rates as soon as March," wrote Ward McCarthy, chief financial economist at Jefferies.

The Fed has a target of 2 percent inflation, though it favors looking at the personal consumption expenditure inflation data, which is under 2 percent. The Fed's dual mandate covers inflation and employment, and inflation has, until recently, been persistently low. The Goldman economists now forecast the PCE inflation reading will be 1.98 percent in January.

Retail sales also were higher than expected, rising 0.4 percent in January. Sales were revised up for December to 1 percent. Excluding automobiles, gasoline and building materials, sales were up 0.4 percent. Economists use that number in calculating gross domestic product, and first quarter forecasts could rise as a result. Goldman economists boosted their first quarter forecast to 2.1 percent, up 0.2 after the retail sales.

As expected, vehicle sales showed the biggest drop in 10 months.

"The core numbers were still good. The consumer is resilient and coming through. In the inflation data, almost half of it was the sharp increase in prices at the pump," said Diane Swonk, CEO at DS Economics.

"Apparel held up. Department stores were up after blood-letting draconian declines in December. Some data you take with a grain of salt, but it is a resilient consumer," she said.

Swonk said she now sees about a 30 percent chance of a rate hike in March. The market had backed off from the idea the Fed could move in March after the dovish statement the Fed made following its last meeting.

"Does it mean a March rate hike for sure? No, but it's an open door," said Swonk. "It's a warmer economy and it was a warmer January. We're around 2 percent growth in the first quarter which is what we expected. It's good fundamentally," she said.

JPMorgan economists noted that rhetoric from FOMC officials has turned "marginally more hawkish lately."

"Almost all Fed speakers have emphasized that the employment mandate virtually has been achieved, while they are closing in on the inflation mandate. Today's CPI number will reinforce the sense that they are closer to achieving their 2.0 percent inflation goal. Of course, given that the upside surprise was located primarily in the core goods category there is a very good chance that much of the strength was a one-off," the economists wrote.

They said they still expect just two rate hikes this year, with the second in September. They also noted that even though there is no press briefing planned for the May meeting, it does not matter.

Yellen emphasized that "all meetings are live" when she spoke before Congress. Wall Street has held to the belief that the Fed would not want to raise rates when there is no briefing planned, where it can explain its move.

Ian Lyngen, head of U.S. rate strategy at BMO, said even though the odds are moving higher, he does no expect the Fed to move in March.

"You're right ahead of Frexit," he said, referring to the French election where a nationalist candidate would like to take France off the euro.

"There's a lot of data between now and March. I do think we might see better odds priced in. I certainly think the Fed would like to go. They just need the cover of the data and other events," said Lyngen.

Treasury yields moved higher after the strong data. The 10-year yield was at 2.49 percent and the 2-year note yield rose to 1.24 percent.

Industrial production was also reported Wednesday, and it was weaker than expected, showing a decline of 0.3 percent. The number was dragged down by a 2.8 percent drop in vehicle production and a 5.7 percent decline in utilities, due to warmer winter weather.