Sticky inflation, resilient economy puts 50 basis point Fed rate hike in play

A run of stronger-than-expected economic data, paired with elevated inflation, has renewed bets on bigger Fed rate hikes.

The Federal Reserve may need to put its foot more firmly on the interest rate pedal next month, traders are indicating Thursday, as sticky inflation, a resilient job market and roaring consumer spending continue to stoke price pressures.

A quicker-than-expected reading for factory gate inflation, which showed producer prices rising on a month-on-month basis and not slowly nearly as much as hoped when compared to last year, has added to market bets that the Fed will need to amp-up the pace of its policy tightening as the economy continues to fire.

Earlier this week, data showing sticky consumer price pressures over the month of January, with a headline rate increase of 0.5%, was quickly followed by the strongest monthly gain for retail sales in two years.

Both of those data points, of course, were presaged by a blowout January jobs report that showed 517,000 new positions added to the economy, taking the headline unemployment rate to a five-decade low of 3.4%.

Weekly applications for jobless benefits, meanwhile, continue to stagnate, suggesting the January pace of hiring -- fueled in part by unseasonably warm weather -- has solid momentum.

The Gap Between Market Bulls and Fed Hawks Grows Wider

And while the Fed has been warning investors that inflation will take longer to tame, with higher rates needed, Chairman Powell's suggestion that the destination of rate hikes is more important that the speed at which they arrive is now getting tested.

"The Fed entered 2023 more optimistic about the growth outlook than private forecasters and more pessimistic about the inflation outlook," said Bill Adams, chief economist for Comerica Bank in Dallas.

"Data since the turn of the year have mostly supported the Fed's view; inflation is proving stickier in early 2023 than anticipated, affirming the Fed's view that further increases in the federal funds target are justified," he added. "The Fed's rate decisions this year would be more complicated if labor market data started falling off a cliff, but if anything the opposite is the case."

The Atlanta Fed's GDPNow forecasting tool, in fact, shows the U.S. economy advancing at a 2.5% clip this quarter, up from the 2.4% estimate it showed prior to the retail sales data and inflation data.

The CME Group's FedWatch tool now suggests a modest 15.1% chance of a 50 basis point rate hike next month in Washington, up from just 9.2% last week and 5.2% a month ago.

The bulk of bets on a Fed Funds rate that's higher than 5% -- a level many Fed officials have said is necessary but markets have been reluctant to believe -- are now in place for the central bank's two-day policy meeting that starts on June 14.

A 50 basis point hike next month, however, might not be as far-fetched as markets expect. Cleveland Fed President Loretta Mester told reporters following a speech in Florida that the January CPI reading was a 'cautionary tale" that could cement the case for faster rate hikes, adding there was a "compelling case" to do so at the last meeting on February 1.

Bond Markets Don't Care About the Debt Ceiling and Neither Should You

Bond markets, notably sensitive to Fed rate signals, have been volatile for much of the week, with benchmark 10-year note yields rising 5 basis points to 3.836% in Thursday afternoon trading, while 2-year notes jumped 5 basis points to 4.638%

"The ten-year Treasury yield has inched higher following the PPI release, and while the market has been able to gain momentum with higher rates, the ten year's climb demands monitoring as it edges closer to 4%," said Quincy Krosby, chief global strategist for LPL Financial in Charlottesville, Virginia, who argues that higher rates don't need to blunt stock gains "as long as it's associated with stronger economic growth.

"However a move above 4% would question if the economic backdrop could continue to maintain a positive outlook," he added.