Surprise inflation report may signal smaller Fed rate hikes in future — if trend continues

Published Tue, Dec 13 202210:55 AM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

The Federal Reserve may be more comfortable with a series of small rate hikes next year if inflation continues to cool, economists say. Stocks surged and bond yields fell sharply early Tuesday as investors bet November's better-than-expected consumer inflation report could mean fewer Federal Reserve rate hikes. But economists also warn the central bank is likely to continue its hawkish stance well into next year, and the size of rate hikes that will be needed to crush inflation is still not clear. The consumer price index rose by just 0.1% from October, and was up 7.1% from a year ago in November. Tuesday's report was the second positive surprise in a row in the monthly data, and the smallest annual decline since December, 2021. Economists surveyed by Dow Jones had expected a jump of 0.3% in the monthly reading, and an annual pace of 7.3%. In October, consumer inflation was running at an annual pace of 7.7%. The Fed began its two-day policy meeting Tuesday, and is still widely expected to raise interest rates by a half percentage point Wednesday, even with the cooler inflation report. That comes after a string of four 75 basis-point rate hikes. A basis point equals 0.01 of a percentage point. "It's good news. Things the Fed expected to move down are moving down," said Diane Swonk, chief economist at KPMG. "What they're worried about is underlying inflation, where labor is the underlying cost of doing things. They still need to see some movement on that." Used vehicle prices, one of the culprit's behind spiking inflation, were down 2.9% for the month, while energy fell 1.6%. Shelter costs, however, continued to rise, up 0.6% for the month, and 7.1% on an annual basis. "There's some good news. Its not enough to stop the Fed, but it's enough to let the Fed slow the pace of tightening," said Swonk. "But it doesn't give them a terminal rate yet. The good news is we love to be surprised on cooler inflation, but it's still not cold. It's not cool. It's not even tepid." As bond yields fell, the futures market reflected lower expectations for Fed rate hikes Tuesday morning. The terminal rate, or end point for Fed hikes, was priced at 4.86% for May 2023, down from nearly 5% earlier, according to BMO. The 10-year Treasury yield fell to a low of 3.43%. Stocks rallied, with the S & P 500 up 1.4% in mid-morning trading, well off its early highs. "I don't think this single read changes much," said Ben Jeffery, rate strategist at BMO. He said the market expects a half percentage point hike Wednesday, but then smaller increases. "Generally, the path was 25 [basis points], then 25. If anything it's taking out the chance of additional 25s," said Jeffery. But Aneta Markowska, Jefferies chief financial economist, said the report makes her consider changing her forecast for another 50 basis-point hike in February. She expects the central bank to raise rates by a half percentage point Wednesday and to end rate hikes at a terminal rate of 5.1% next spring. Since March of this year, the Fed has raised its fed funds target rate to a range of 3.75% to 4%. "There's a real possibility that they'll go 25 instead in February, but they'll go at 25 basis point increments until they've done enough. It's definitely good news," Markowska said.