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Market Reacts to Higher Inflation: Assessing the Fed's Response

In the wake of a surprising uptick in January's consumer-price-index report, the financial markets exhibited a noticeable reaction, with the Dow shedding 525 points and the Russell 2000 index of small-cap stocks plunging 4%. The unexpected acceleration in inflation to 3.1% year-on-year, exceeding economists' projections of 2.9%, prompted speculation about the Federal Reserve's potential interest-rate decisions.


Traders, as reflected by the CME Group’s FedWatch Tool, now anticipate the Fed's first interest-rate cut to occur at the June 12 meeting instead of the previously expected May 1. However, it's crucial to maintain perspective, considering January's inflation figure, while surpassing expectations, still marked a decline from December's 3.4% and represented the slowest reading since June.

Core inflation, excluding food and energy, remained steady at 3.9% in January, compared to the previous month. While this figure may seem concerning, it's essential to note that just six months earlier, in July 2023, core inflation was at a higher 4.7%.

Goods inflation continued to register negative growth, driven by falling prices for items like apparel and used cars, a consequence of resolving pandemic-related shortages. The real concern lies in the services sector, where core prices, excluding energy services, accelerated by 0.7% in January, up from December's 0.4%.

The bearish argument suggests that the rise in services costs is a result of a tight labor market, potentially keeping the Fed on hold until employment market conditions cool down. However, the recent robust jobs report contradicts this notion.

Upon closer inspection, some signs suggest that January's spike in services inflation may be more noise than signal. Notably, shelter costs saw an increase to 0.6%, compared to December's 0.4%, prompting analysts to question the legitimacy of this surge. Research firm Capital Economics described this jump as "suspicious looking" and expects more disinflation in the Consumer Price Index (CPI) measures based on existing rents.

Similarly, economists at BNP Paribas noted a sawtooth pattern in the official data on owner-equivalent rents, indicating fluctuations recently. If newly signed leases continue moderating, this could eventually translate into slower inflation readings in Labor Department data. Importantly, the Fed's preferred inflation measure, from the Commerce Department, places less emphasis on housing costs.

While investors are optimistic about a potential quick rate cut, it's crucial to approach this with caution. The Nasdaq-100 index experienced a 24% surge between November and Monday's close, and a measured approach may be prudent given the current valuations. However, it's essential to remember that the broader U.S. economic outlook, characterized by resilient job growth and cooling inflation, remains unchanged. Investors are advised not to hit the panic button, as the Magnificent Seven don't represent the entirety of the American economy.

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