How financial conditions might play into Fed’s thinking after October’s CPI

Financial markets were jubilant over Tuesday’s data showing that U.S. consumer prices eased by more than expected in October, with Treasury yields plummeting on expectations the Federal Reserve will refrain from raising interest rates further and might even lower borrowing costs.

In a nutshell, financial conditions suddenly became looser, with the benchmark 10-year yield
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at 4.46% in New York afternoon trading or down by more than half a percentage point from its October peak. Right now, conditions are “much more accommodative” than when Fed officials first suggested higher long-term yields could do the work of tighter monetary policy and take the place of a rate hike, according to Will Compernolle, a macro strategist for FHN Financial in New York.

The jury is out on how much a continuation of looser financial conditions will matter to central bankers. At one point in Tuesday’s session, both the 10-year yield and the policy-sensitive 2-year yield
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were heading for their biggest one-day declines in more than six months as traders revved up expectations for at least four Fed rate cuts in 2024.

Tuesday’s October CPI inflation report “will be very welcome to the Fed, though it will inevitably make the Fed’s challenge of restraining market optimism and financial conditions more difficult too,” according to New York-based advisory firm Evercore ISI.

In a note, Evercore’s Vice Chairman Krishna Guha and others wrote that “the Fed’s challenge is that the market sees this and is trying to jump to the endgame, risking a larger/sooner easing in financial conditions than the Fed itself would like to see under prudent upside inflation risk management principles. So expect Fed officials to maintain a very cautious and relatively hawkish tone.”

Indeed, there’s plenty of reasons to remain careful about reading too much into one report.

After Tuesday’s data, Federal Reserve Bank of Richmond President Thomas Barkin said he’s not convinced inflation is on a clear path toward 2% despite recent progress in curbing price pressures.

Some economists also said October’s CPI report isn’t the game changer that markets think it is. And FHN’s Compernolle said that if the Fed’s favorite inflation gauge, the personal consumption expenditures index (PCE), shows “horizontal momentum” when the October data is released later this month, there could be some on the Federal Open Market Committee “who feel the lower bond yields necessitate a higher fed funds rate.”

Read: Economists in hawkish camp don’t surrender in wake of October consumer-inflation print

At Hirtle Callaghan & Co., a West Conshohocken, Pa.-based firm which manages $18.5 billion in assets, Brad Conger, deputy chief investment officer, said that October’s CPI readings validate the Fed’s “wait-and-see” approach and that “it will take a rather long series of this order of magnitude to give them confidence to ease policy.”

Meanwhile, “we worry that the recent easing of financial conditions and energy prices could easily start to counter the restraint,” Conger wrote in an email on Tuesday.

In addition to a broad-based decline in Treasury yields, all three major U.S. stock indexes
DJIA

SPX

COMP
were higher as of Tuesday afternoon. The Dow Jones Industrial Average surged almost 500 points on a buying frenzy as investors also cheered Tuesday’s low “supercore” inflation figure that acts as a proxy for labor costs.

Just last week, Fed Chairman Jerome Powell said that the Fed is wary of “head fakes” from inflation, or temporary improvements that only reverse over time.

If Tuesday’s CPI data for October isn’t a “head fake,” “the Fed may be able to accept a loosening of financial conditions in order to prevent a recession,” said Lawrence Gillum, a Charlotte, North Carolina-based fixed-income strategist for broker-dealer for LPL Financial. “If it is a head fake, then the Fed will talk up the need for higher long-end yields. It will probably take a couple more months of this type of report or better to see whether that plays out.”