Softening inflation data for May likely has bought the Federal Reserve at least a month, though not much more, before it has to figure out what to do next. With the all-items consumer price index rising 4% from a year ago, policymakers can take a month to assess the impact of the previous 10 interest rate increases. Following the CPI release Tuesday morning, markets priced in a 95% probability that the central bank will skip a hike at its two-day meeting concluding Wednesday, according to CME Group data . However, the market was still putting a 63% probability that the pause won’t last long, and that officials will go ahead with one more increase at the July 25-26 meeting. “The latest consumer price inflation data doesn’t change the Fed outlook for a June rate hike skip, but it illustrates the ‘should I stay, or should I go’ dilemma that the Fed faces when considering further rate increases,” wrote Gregory Daco, chief economist at EY-Parthenon. “Some Fed policymakers,” he added, “will interpret the persistent (and backward-looking) core inflationary pressure and an indication to ‘go’ on tightening, while others with more of a forward-looking policy framework will see justification to ‘stay.'” Indeed, the report, despite its headline-grabbing dip showing inflation at a more than two-year low, offered a mixed bag when looking at the future. Stripping out the impact that surging energy prices had last year when comparing them to this year, core CPI still rose 0.4% for the month and 5.3% from a year ago. That’s a number far from the Fed’s 2% inflation goal and reason for officials to keep tightening in July unless the data in between now and then corroborate further progress. “Market expectations are too settled on the pause at this point and the Fed will not want to surprise investors,” said Jim Smigiel, chief investment officer at SEI. “However, with core still running with a 5-handle, the next move from the Fed is another hike in July and perhaps one more after that (which is not priced in at this point).” For months, markets had been pricing in rate cuts this year, but they have recently shifted. The theory behind cutting is that the economy is likely to enter a recession this year, forcing the Fed to capitulate. However, multiple officials have emphasized that inflation is too high, and they don’t foresee policy loosening at least through 2023. After this week’s meeting, policymakers will release their “dot plot” rate projections for the next few years, plus their collective outlook on inflation, gross domestic product and unemployment. The dot plot is expected to show no rate reductions this year, though following years could indicate less certainty and a growing divide among members. Krishna Guha, head of global policy and central bank strategy at Evercore ISI, expects to see a more hawkish and split Fed. “The Fed will not hike in June; the decision will be positioned as a one-meeting skip to July and slowing down to a pace of one hike every other meeting rather than an extended pause,” Guha said in a client note. “The Fed will message a default to go again in July if the tone of the data remains unchanged but no hard lock on July; and there will be a roughly one third, one third, one third split in the SEP between those who expect no more hikes, one more hike and two more hikes (6 maybe 7 hawks out of 18.)” Fed Chair Jerome Powell could have a difficult task at his post-meeting news conference explaining the positions of his fellow policymakers. Risk markets this year have been riding a wave of Big Tech surges to carve out a solid gain , though such rate-sensitive sectors could pull the market lower again. The retreat on inflation, then, presents both an opportunity and a challenge for a central bank that was caught off guard by the big price surge. “Such rapid headline disinflation will make it harder for the Fed to justify raising rates again, but we can’t rule out a July hike yet,” wrote Ian Shepherdson, chief economist at Pantheon Macroeconomics. “Everything depends on the data, but we expect both a softer employment report and a 0.2% core CPI for June, so our base case remains that the Fed is done. But it will be close.”
