February inflation came in hot but in line with expectations, with headline consumer price index (CPI) rising 0.4% month/month (m/m) and 6.0% year/year (y/y) and core CPI rising 0.5% m/m and 5.5% y/y. This highly anticipated print was overshadowed by the fallout from regional bank failures, which could also impact how the Federal Reserve (Fed) approaches its March rate decision.

Markets priced in a 68% chance of a 50 basis points (bps) rate hike at the March Federal Open Market Committee (FOMC) meeting after Chair Powell contemplated increasing the pace of hikes during his testimony to Congress. The expected ceiling on the federal funds rate shot up to 5.7%, with a year-end expectation of 5.6%. On Monday, while markets grappled with regional bank failures, the ceiling fell to 4.7%, with a year-end expectation of 3.8%, before rebounding on Tuesday to a ceiling of 4.9% and a year-end rate of 4.4%.

Although inflation is still elevated, it is likely to continue to fall over the coming months. With the added pressure to the financial system from regional bank failures, the FOMC could hike 25bps in March and then pause, bringing rates to 4.75-5.00%. If financial stability or liquidity becomes a deeper concern, the Fed could consider slowing quantitative tightening as well.

It is not just the bank failures but also February data that supports winding down the hiking cycle: 

• Inflation – Shelter, which lags already moderating rents, contributed to 70% of the overall monthly increase in CPI. Without it, both headline and core CPI would have increased 0.2% m/m. Although services, as evidenced by increasing airline fares and hotels, still has progress to make, a fading consumer should help, and headline CPI should fall to 4% by the summer.
• Inflation expectations – The New York Fed’s survey of consumer expectations showed a 0.8%-point decline in 1-year inflation expectations to 4.2%, the lowest since May 2021.
• Wages – Average hourly earnings increased a modest 0.2% m/m in February. Not only has wage growth slowed, but CPI has outpaced it for 23 months, eroding consumer purchasing power.
• Financial conditions – Financial conditions have tightened significantly over the last few days, reflecting market turbulence and a higher cost of capital. The Bloomberg Financial Conditions Index nearly matched peak tightness from September 2022.

Inflation is not the only consideration for tightening; the Fed must be attuned to financial stability risks as well. While inflation may not be falling as fast as the Fed would like, it is slowing, and the economy and markets are responding to tighter monetary policy, underpinning our view that the rate hiking cycle is nearly over. 

09jw231503155807