February 12, 2025

QuickTakes

Fed Rate Cuts On Ice

As Inflation Heats Up

Today's hotter-than-expected January CPI inflation did some damage to bonds, raising long-term Treasury yields roughly 10bps. Headline and core CPI rose 0.5% and 0.4% m/m, respectively, as many companies set their annual price increases. But this wasn't a start-of-the-year blip; inflation has been rising since last summer (chart). So after 100bps of federal funds rate (FFR) cuts from September 18 through December 18 last year, the Fed's easing cycle is on pause for the remainder of the year, as we've been predicting.

But a side effect of Trump 2.0 is that Fed-related economic data, like inflation and labor market news, are not the only headlines which move markets. President Trump said that Russia agreed to begin negotiations "immediately" to end the war in Ukraine, helping give stocks a lift and leaving them mostly unchanged on the day.

Crude oil prices fell around 2.5% today on that news. Considering the linkage between oil and breakeven inflation priced into Treasury yields, an end to the Russia-Ukraine war and increased US energy production could help lower long-term yields (chart). It's also worth considering that the Treasury auctioned off $42 billion of 10-year notes today, which likely helped raise yields.

That said, today's CPI shows that the economy is not out of the woods on inflation. Here's some devils in the details which cast doubt on some FOMC participant's view that the current FFR is "restrictive" and should be lowered:

(1) Reacceleration. Headline and core CPI are now both at-or-above 3.0% y/y (chart). Sticky services inflation became even stickier, as supercore CPI rose 0.75% m/m.

One culprit of supercore's jump was auto insurance, which rose 2.2% m/m and 11.8% y/y (chart).

We expect disinflation to resume next month. But there are only so many categories that can be stripped out before one misses the forest for the trees. For instance, the rate-cut camp has pointed to expectations for shelter CPI inflation to fall. But shelter prices were up 0.4% m/m last month, accounting for nearly 30% of the total increase in headline CPI.

Another legitimate concern is that goods inflation is rebounding while progress on services inflation has stalled. CPI goods rose 0.8% y/y in January as nondurables prices increased 1.6% (chart). Durable goods prices are still falling but at a slower pace. If durable goods prices started to inflate, which is possible with tariffs starting to take effect, core CPI might creep toward 3.5%. Should tomorrow's PPI come in hotter-than-expected as well, stock and bond prices might decline in anticipation of a PCED print that sparks bets on a potential FFR hike this year.

(2) Powell testimony. Fed Chair Jerome Powell was on the hill today giving an update to Congress. One thing which got our attention was that he said that, in hindsight, the Fed could have ended quantitative easing (QE) earlier. The FOMC only started to reduce the size of Treasury and mortgage-backed securities purchases when CPI was already at 6.9% (chart).

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