Investors have gotten more bad news on the inflation front today, with one popular inflation measure coming in higher than expected. However, investors have managed to shrug off the disappointing news, sending the S&P 500 higher by approximately 1% in morning trading.
On Tuesday morning, the Labor Department reported the consumer price index, or CPI, rose 3.2% year-over-year in February, up from a 3.1% annual gain in January and above the 3.1% increase economists were expecting. On a monthly basis, the CPI gained 0.4%, in-line with economist estimates.
Year-over-year CPI inflation hit a 40-year high of 9.1% in June 2022, but the latest CPI reading is further evidence the Federal Reserve has hit a bump in the road in its disinflation efforts. Annual CPI inflation readings have been inconsistent and ranged between 3.1% and 3.7% during the past eight months after dropping as low as 3.0% in June 2023.
The Numbers
In February, core CPI inflation, which excludes volatile food and energy prices, was up 0.4% on a monthly basis and up 3.8% from a year ago. Economists had forecast a 3.7% annual gain.
Other important numbers came in mixed:
- Food prices were flat month-over-month but up 2.2% compared to a year ago.
- Shelter costs continue to rise, gaining 0.4% compared to January and 5.7% compared to February 2023.
- Energy prices were up 2.3% on a monthly basis but are down 1.9% over the past 12 months. February marked the twelfth consecutive month that energy prices have declined on an annual basis.
- Gasoline prices were up 3.8% month-over-month but were down 3.9% compared to a year ago.
The latest CPI numbers come after the Labor Department reported the U.S. economy added 275,000 jobs in February, exceeding economist expectations of 198,000 new jobs. The Labor Department reported U.S. wages were up 4.3% year-over-year in February, while the unemployment rate rose to 3.9%.
The February CPI reading is discouraging news for Americans hoping the worst of the U.S. inflation problem was in the rearview mirror heading into 2024.
In late February, the Commerce Department reported the core personal consumption expenditures price index, or PCE, was up 2.8% on an annual basis in January, down from a 2.9% year-over-year gain in December. Core PCE is the Federal Reserve’s preferred inflation measure.
Why CPI Matters
Taming inflation has been the Federal Reserve’s top priority since early 2022.
The Federal Open Market Committee has raised interest rates 11 times since March 2022 in an attempt to bring inflation down to the Fed’s 2% long-term target. The FOMC’s current federal funds rate target range is 5.25% to 5.5%, its highest level in 22 years.
The Fed is also allowing up to $60 billion in Treasury securities and $35 billion in agency mortgage-backed securities to mature and roll off its more than $7.5 trillion balance sheet per month.
The Fed had paused its rate hiking campaign, starting in July 2023. But Tuesday’s CPI reading may mean a potential Fed pivot to interest rate cuts is not coming as soon as investors had hoped.
Skyler Weinand, chief investment officer at Regan Capital, says the key takeaway from Tuesday’s CPI report may be that the FOMC will likely postpone its first interest rate cut until September rather than June as previously projected by many investors.
“The Fed usually cuts interest rates to get ahead of an impending economic slowdown, and with the economy running so strong currently, it’s difficult to justify any rate cuts this year. Still, the Fed is likely to cut interest rates one or two times this year, as an acknowledgement that inflation has meaningfully decelerated, even if it’s not quite fully back to its 2% target,” Weinand says.
According to CME Group, markets are currently pricing in a 97% chance the FOMC will maintain interest rates at their current levels at its upcoming meeting that concludes on March 20. The market is also pricing in a nearly 80% chance the Fed will cut interest rates by at least 75 basis points, or bps, by the end of the year.
How Will the Fed React?
In its January meeting minutes, FOMC officials indicated they need to see further evidence inflation is receding before they begin cutting interest rates. They also noted the “risks of moving too quickly” in easing monetary policy.
Hawks calling for a delay in interest rate cuts argue so-called “sticky” inflation could make the last leg of the Fed’s inflation battle more difficult than anticipated. Doves calling for a Fed pivot to rate cuts are concerned the monetary policy tightening measures of the past two years could have a delayed, cumulative impact on the economy in 2024.
Larry Tentarelli, chief technical strategist at Blue Chip Daily Trend Report, says the FOMC is fortunate that recent economic data has been strong enough for the Fed to continue to delay its first rate cut.
“In our view, unless inflation starts to drop and come in below forecast, most notably CPI and core PCE, then we expect the Fed to take a patient and measured approach to any potential rate cuts. If there is any notable weakness in the jobs market, that would increase the chance of a Fed rate cut by June,” Tentarelli says.
Is a Recession Coming?
The Federal Reserve is attempting a balancing act of managing interest rates to bring down inflation without tipping the U.S. economy into a recession. Higher interest rates increase borrowing costs for companies and consumers, slowing economic activity.
However, the labor market has remained resilient despite the Fed’s aggressive monetary policy tightening measures. In addition, S&P 500 companies have reported two consecutive quarters of positive year over year earnings growth.
While the economy seems stable for now, the New York Fed’s recession probability model suggests a 58.3% chance of a U.S. recession sometime within the next 12 months.
Fortunately, the S&P 500’s positive momentum in 2023 has carried over into 2024, indicating that Wall Street remains optimistic about the economic outlook. The S&P 500 is up 7.6% year-to-date on a total return basis and has made its first new all-time highs in roughly two years.
Will the Bull Market Continue?
Elevated interest rates have historically hit growth stocks particularly hard because higher rates have a negative impact on discounted cash flow valuations. However, that trend has reversed in the last 12 months. The Russell 1000 Growth Index is up 48.3% in the past year, while the Russell 1000 Value Index is up just 20.6%.
The technology sector has been a particularly strong performer as of late, led by a surge in stocks exposed to artificial intelligence technology. S&P 500 technology sector companies have reported 18.9% earnings growth in the fourth quarter of 2023 boosted by AI chipmaker Nvidia (NVDA). The Technology Select Sector SPDR Fund (XLK) is up more than 53% in the past year.
Stock market bulls see the stock market rally as a sign the economy is in the clear. But critics have pointed out that the bull market may be more fragile than it appears. The bull market has been led by a handful of mega-cap technology stocks, and bull market skeptics argue tech sector valuations have grown bloated.
Jeffrey Roach, chief economist for LPL Financial, says the U.S. labor market may soon start to cool.
“Firms will likely slow the pace of hiring in the coming months and shrink payrolls as indicated in the recent layoff announcements. However, the recent strength in the job market will likely keep the Fed on hold in the coming meetings,” Roach says.
What’s Next?
Investors will be monitoring the Federal Reserve’s commentary on the economy at its upcoming meeting on March 19 and 20. The Fed is also slated to release its updated economic projections, and investors will be focused on any potential changes in its inflation outlook.
In the meantime, the U.S. Census Bureau releases its February Retail Sales report on March 14 and the University of Michigan publishes its preliminary U.S. Consumer Sentiment Index reading for the month on March 15.
The Fed will get its next key inflation reading on March 29 when the Bureau of Economic Analysis releases its February core PCE reading. Finally, the FOMC will be watching to see if the U.S. labor market remains hot when the Labor Department releases its February jobs report on April 5.
