It's only a matter of time before Wall Street's biggest fear holds 'the Fed's feet to the fire'
- The prospect of rising inflation and the Federal Reserve's possible reaction to it is Wall Street's favorite new thing to worry about.
- After years of false alarms, "a sustained rise in inflation will hold the Fed's feet to the fire," according to Capital Economics.
- It's "only a matter of time before Fed officials start dropping more hints that they are prepared to step up the pace of monetary tightening," they write in a research note.
Wall Street is getting antsy about inflation again, as investors worry a combination of tax cuts and a low jobless rate will prompt Federal Reserve policymakers to raise interest rates more quickly than anticipated.
The market's adjustment for Fed rate hike expectations has been rather abrupt, with traders who once doubted the central bank's own estimates for three more rate increases this year now betting on as many as four policy tightenings, with possibly more next year.
Yet up to now, the market's reticence over a potentially more hawkish Fed has not been corroborated by central bank speeches and statements, which continue to emphasize the intention to remain gradual and measured in tightening monetary policy.
Soon, marquee Fed speeches, especially congressional testimony by new Fed chair Jerome Powell next month, will set the tone for stocks and bonds.
"A sustained rise in inflation will hold the Fed's feet to the fire, and we think it will prompt the Federal Open Market Committee to raise rates four times this year," Michael Pearce, senior economist at Capital Economics, wrote in a research note.
The Fed started raising interest rates in December 2015 but has done so at the slowest pace ever, boosting its benchmark interest rate five times since to a range between 1.25% and 1.5%. The Fed left official borrowing costs at zero for seven years in response to the Great Recession and its aftermath.
US consumer prices rose 2.1% in the year to January, above forecasts for a 1.9% gain. Inflation has been running below the Fed's 2% target for much of the economic recovery.
"With inflation running a little hot, it will be interesting to see if new Fed Chairman Jerome Powell strikes a more hawkish tone in his testimony to Congress in a couple of weeks' time," Pearce said.
"We think it is only a matter of time before Fed officials start dropping more hints that they are prepared to step up the pace of monetary tightening. That would provide additional fuel to the steady rise in bond yields seen over the past six months."
Pearce says the dollar's depreciation over the last year creates further inflationary pressures already present in the economy.
This "has already fed through to higher prices of imported goods and a pick-up in producer price inflation," Pearce added. "Not all of that increase will be passed onto consumers but, based on past relationship, the acceleration in producer goods prices points to a pick-up in consumer core goods inflation from -0.6% in January to around 0.5% by the end of the year."
As 10-year Treasury note yields approach 3%, minutes from the Fed's January meeting will offer some insights into how widespread the renewed inflation worries are among policymakers themselves.
However, given the amount of turnover taking place at the central bank, including a change of leadership with the start of Jerome Powell's tenure as chair, the report may be too backward looking to offer any predictive insight.
Pearce expects the annual rate of core inflation "will jump back up in the spring, once last year's big drop in wireless telephone service prices falls out of the comparison."
Inflation is likely to edge higher from there, reaching 2.5% by the end of 2018, Pearce added. The consumption expenditures index excluding food and energy, he said, "is rebounding from a lower level, but we expect that too will be above the Fed's 2% goal by year-end."
