What happened?

The latest CPI data confirmed that inflation remained robust in February, with core CPI up 0.5% month-over-month (MoM) and 5.5% year-over-year (YoY), right in line with the market’s expectations.

Given the past week’s banking turbulence and the in-line inflation data, the details of the CPI release matter less than they normally would, and generally match the existing picture of inflation dynamics. Inflation has moderated somewhat relative to its level a few months ago but still remains too high, requiring further monetary tightening.

Services inflation remains our focus. Shelter inflation is still hot, as we’d expect given the typical lag between housing sale prices and rent/owners-equivalent-rent inflation in CPI data.

Impact on next week’s Fed meeting

With both recent labor market data and inflation data showing persistent strength, we expect this would normally support the Fed in hiking rates by 50 b.p. in their March 22 decision. However, given the recent turbulence in the banking sector, we suspect the decision will instead be between a 25 b.p. hike this month and a “delayed hike,” meaning no March hike but a strong signal of high-probability rate hikes in both May and June.

While recent macroeconomic data was hotly anticipated and closely watched, we believe that ultimately the Fed’s March decision will come down to the FOMC’s assessment of the stability of the financial system. They won’t want to potentially worsen the situation by tightening monetary policy into a distressed environment. At the same time, allowing inflation to persist at current levels would also not be a good outcome—it could allow inflation expectations to rise again, exacerbating the losses from Treasuries which led to SVB’s initial losses.

If the Fed had to decide today, they would likely not raise rates. Yet there is time between now and the meeting, allowing the banking system to potentially stabilize in the interim. Our best estimate is that the situation will have settled enough by then to allow a 25 b.p. hike next week. However, that is extremely contingent on increased stability in the banking sector.

The market is now pricing in a lower terminal rate than it had been, which is likely correct. One puzzle during this cycle had been the fact that 2022’s sharp rate increases hadn’t “broken” anything. Now they have. That suggests the rates are having an impact and that there is an effect beyond what we’re detecting in market-based financial conditions indices. This fact pattern supports a lower terminal rate.

However, the market is also now pricing in an earlier start to rate cuts, which is a less obvious outcome to us. It still seems that the path to rate cuts runs through a downturn in the labor market and an established disinflationary process, which we have not yet seen evidence for. Unless the banking turbulence turns into a full-blown crisis, we would still expect that to be the case.

Treasury market volatility

The moves in Treasury yields over the past week have been extremely large. The implied Fed Funds rate for September was 5.69% at the market’s close on Wednesday, March 8. That fell to 3.91% as of Monday’s close, a decrease of 1.78 percentage points. As of 11 a.m. Tuesday, that had already returned to 4.65%. The 61 b.p. drop in 2-year Treasury yields on Monday was the largest one-day decline since 1982. The demand for Treasuries came from a sharp flight to safety, which is now easing, and as the market calms down, it may return to more deliberate pricing expectations for the Fed’s rate hike path.

The key question for rates

Over the coming months, the new driver will be the extent to which the issue in regional banks acts as a disinflationary force on the economy. It’s too early to assess the magnitude at the moment—it will depend on the extent to which consumer and corporate behavior changes as a result. With large deposits in failing institutions being guaranteed, consumer and corporate behavior may not change materially. In that case, the crisis of confidence could pass quickly without damage to the economy. However, that remains to be seen before we reassess our medium-term outlook for monetary policy. Our main expectation recently has been for elevated macroeconomic uncertainty—the latest events have raised the degree of that uncertainty.