January's inflation report rattled markets as investors weighed whether the Federal Reserve would take drastic measures to curb rising prices — including a half-percentage-point interest rate hike in March. The consumer price index for all items rose 0.6% in January on a monthly basis, or 7.5% year-over-year, well above Dow Jones' estimates of 0.4% and 7.2%, respectively. "This is burning inflation. It's broad based. It confirms for the Fed that variants are more inflationary than disinflationary, and they are behind the curve," said Diane Swonk, chief economist at Grant Thornton. Bond yields move opposite prices. The benchmark 10-year Treasury yield topped 2% for the first time since 2019. The tech sector slid, but major banks, like JPMorgan, were higher on expectations that a higher rate environment would help their profitability. Traders in the fed funds futures market immediately bet on the possibility of a 50 basis-point rate hike — or a half-percentage-point increase — from the Fed in March, rather than the quarter-point hike that had been expected by most economists. "It's quite a report. I don't think 50 basis points happens, but the market's got just about 50/50 between 25 and 50 basis points priced in," said Wells Fargo's Michael Schumacher. "People are really spooked." He noted that the fed funds futures market was now close to pricing in six rate hikes for this year, up from just over five. The two-year Treasury yield, which closely reflects the central bank's policy, rose to nearly 1.50%. "I wouldn't say it's unglued, but it's certainly pricing in a ton from the Fed," said Schumacher. "Inflation's not backing off." Forecast updates in light of the data Swonk said she changed her forecast to now include a half-point hike for March, after the 8:30 a.m. ET CPI report. "The problem is how much does the Fed have to move?" she said. "In theory, it's nice to say they can raise rates to tamp down inflation, but you're now trying to get a boiling pot down to tepid. That's a very hard thing to do without dumping a bunch of ice in it." Swonk said the hotter inflation trend could also make the Fed consider winding down its balance sheet . The central bank is holding nearly $9 trillion in assets. "Now how rapidly does the Fed allow its balance sheet to also run off? It would like to have short-term rates be the primary tool, but there's a set of tools," she said. "The real issue is can they really engineer a soft landing that doesn't bleed into employment. In theory, it sounds great to hit the brakes before you get to the stop light, but in reality if you're hitting the brakes late, you're risking an accident." Swonk noted that some of the areas where prices were rising were the labor intensive domestic services categories, like lawn care and snow removal. Economists have said they expect to see inflation move from goods prices to services prices as supply chain issues ease and labor costs rise. "There's been a ton of discussion about when does inflation peak," said Schumacher. "Our economists would tell you it's either March or April .This number is not really consistent with being at the peak. It's still climbing. Is a peak a jagged plateau or are we still going up? This number tells me we're going up at a decent clip. It's pretty worrisome." Schumacher said he expects the 10-year yield's move to 2% to have a psychological impact on investors. "You can't say it's a super-low yield environment anymore. The 10-year yield is higher now than it was at the end of 2019. I think this makes people reassess their assumptions of how high it can go," he said. "There's a lot of worry now about the inflation peak being longer than a lot of people thought," Schumacher added. "I think it's just a wake-up call for a lot of investors out there."
U.S. Federal Reserve Board Chairman Jerome Powell speaks during his re-nominations hearing of the Senate Banking, Housing and Urban Affairs Committee on Capitol Hill, in Washington, U.S., January 11, 2022.
Graeme Jennings | Reuters
January's inflation report rattled markets as investors weighed whether the Federal Reserve would take drastic measures to curb rising prices — including a half-percentage-point interest rate hike in March.