MNI: Fed Rates Likely Headed Above 5% Despite Cooling CPI

The Federal Reserve is likely to lift its benchmark interest rate above 5% to restrain inflation as long as the job market remains overheated, even with consumer prices falling in December for the first time since early 2020, former officials told MNI.

Markets are pricing another downshift in the pace of rate hikes to a quarter point next month and a rate peak around 4.9% after CPI cooled for a sixth straight month and several Fed officials said they would support a 25 bp move. Investors are also expecting a half-point rate cut by year-end, even with the latest FOMC dot plot calling for a 5.1% rate in December.

Encouraging inflation data isn't likely to shake Fed officials' resolve to raise rates above 5% and keep them there all year, the former officials said. That comes after CPI surged to 9.1% last summer, creating fears of embedded price gains.

"I expect them to step down to 25-bp steps. I think they’ll do at least two and probably three," former New York Fed president William Dudley told MNI. "There is some risk of a pause and then a restart but not likely. They don’t want that, and their preference would be just to keep rates elevated for longer."

TREND INFLATION STILL HIGH

Support for ratcheting down to a 25-bp move at the next meeting appears to be growing, former Atlanta Fed President Dennis Lockhart told MNI. That said, Fed Chair Jerome Powell "has been clear in past comments that the committee prefers overshooting somewhat to the error of undershooting."

Following Thursday's inflation report Philadelphia's Pat Harker said he favors a few more quarter-point moves while St. Louis President James Bulllard said he wants to go faster to bring rates above 5%. Tom Barkin said in Richmond that while he favors going slow, rates could end up higher to curb price and wage inflation.

The FOMC is seeking a stopping point that gives them confidence disinflation will gain momentum. It's not yet clear that trend inflation is solidly on its way down, the former officials said.

The Cleveland Fed's median and trimmed mean CPIs were both up 0.4% for the month, rising 6.5% and 6.9%, respectively, from a year earlier. The trimmed mean PCE inflation from the Dallas Fed is still running over 4.5%, noted former New York Fed research director Stephen Cecchetti, now professor at Brandeis International Business School.

"The important thing for the FOMC is to make sure that the policy rate gets above trend inflation. This surely means going to 5% or higher," Cecchetti said. The fed funds rate was raised 50 bps in December to a 4.25%-4.5% target range.

LABOR MARKET PROBLEM

Powell has signaled he is looking for signs that the overheated labor market is losing steam as assurance inflation will fall toward 2%. Wage growth moderated in December but employers added another 223,000 jobs, twice as much as needed to absorb new workers, and the unemployment rate sank back to a 50-year low.

"To the extent that the labor market is the key focus driving policy, I don't think there has been enough movement toward supply-demand balance to justify a stepdown at the next meeting," Lockhart said, adding he still sees a case for a second straight 50-bp hike in February.

U.S. labor market strength remains key to policymaker deliberations, Dudley said. "Without considerable softening it will be hard to be confident that you will get back to 2% inflation."