Inflation Shows Signs of Cooling as Fed Weighs Next Move

Crucial to investors’ assessments is the pace of inflation and the path of interest rates set by the Federal Reserve to temper rising prices.

Wednesday’s reading of the Consumer Price Index for March arrived largely in line with economists’ expectations. That bolsters the likelihood that the Fed will raise interest rates in May, according to Lauren Goodwin, an economist at New York Life Investment.

That would typically be bad for the equity market, but investors appeared to look past the data to how it might affect what comes next.

Given the shock to the banking system, in part stemming from higher interest rates, further rate increases also raise the possibility that the Fed may go too far and tip the economy into recession. In that environment, inflation could fall more quickly, with some investors betting that the Fed could cut interest rates later this year, supporting financial markets.

“It’s a little bit of mental gymnastics,” Ms. Goodwin said. “Over the past couple of weeks following the bank failures, the market has become much more focused on recession. If this data makes a rate increase more likely in May, then it makes a recession even more likely. The market is seeing that the disinflationary process, while slow, is intact, with recession likely leading to lower interest rates.”

Prices in interest rate futures markets, which allow investors to bet on where interest rates are going, show expectations tilting toward the Fed making a quarter-point increase in May.

Following the latest inflation data, the two-year Treasury yield, which is sensitive to interest rate expectations further out in time, fell sharply to below 4 percent after rising above 5 percent just over a month ago.