Investors are more worried about inflation than a weakening economy

Fri, Apr 26, 2024, 3:20 AM 4 min read

The latest data from the Bureau of Economic Analysis showed the "core" Personal Consumption Expenditures (PCE) index, which excludes the volatile food and energy categories, grew by 3.7% year over year in the first quarter, above estimates for 3.4% and significantly higher than 2% gain seen in the prior quarter.

This marked the first quarterly increase in the Fed's preferred inflation gauge in a year, underscoring concerns that the central bank may not cut interest rates as quickly as it has projected.

Losses in markets, sparked by disappointing earnings from Meta on Wednesday, accelerated on Thursday following the BEA report. All three major indexes were down more than 1% midday while bond yields spiked, though they recovered some of those steep losses by the close. The 10-year Treasury yield (^TNX), a recent headwind for stocks, ticked higher to reach above 4.7% at one point for the first time since early November.

"The difficult part [of Thursday's data release] for the Fed and for the markets was core PCE was the inflation print," Deutsche Bank senior US economist Brett Ryan told Yahoo Finance. "And that's really what is troublesome from the Fed's perspective and why the market reacted quite negatively because it really puts the Fed in an awkward position, and you start to question whether they can cut at all this year."

He added that the data could have implications for a separate inflation print scheduled for release on Friday. Ryan notes that Thursday's reading on price increases for the quarter indicates that either March's PCE reading will be hotter than expected or revisions will show inflation was actually higher than previously thought in January and February. Neither bodes well for rate cut prospects.

Expectations for Fed rate cuts, which had already scaled back significantly this year from a peak of nearly seven cuts in early January, fell further on Thursday. Markets are now pricing in just one rate cut this year, per Bloomberg data.

The key to this move has been a rewriting of what consensus expected for inflation this year.

"Forecasters thought 'mission accomplished.' Instead, we now have a red flashing warning sign," economist Jason Furman, who served as chairman of the Council of Economic Advisers under President Barack Obama, told Yahoo Finance.

He added: "The Fed will not be able to be reassured enough about inflation to cut rates anytime this year, maybe in December, probably not. The only thing that's going to get us Fed rate cuts anytime soon is a much more rapid deterioration in the job market than I expect to get."

Federal Reserve Chair Jerome Powell recently reiterated that the Fed won't be cutting rates until it has "greater confidence" in inflation's decline.

"The recent data have clearly not given us greater confidence and instead indicate that it's likely to take longer than expected to achieve that confidence," Powell said on April 16.

Elsewhere in Thursday's data release, economic growth for the quarter fell short of expectations. The advance estimate of first quarter US gross domestic product (GDP) showed the economy grew at an annualized pace of 1.6% during the period. Economists surveyed by Bloomberg estimated the US economy grew at an annualized pace of 2.5% during the period.

Economists noted a large part of the slowdown in economic growth came in volatile categories that could rebound in the next quarter, leaving the increase in inflation as the most crucial part of Thursday's economic data dump.

"There was very little to be worried about in terms of real GDP and real growth in this print," Furman said. "There was a lot to be worried about in terms of inflation."

Many strategists have argued the market could still chug higher even if the Fed doesn't cut interest rates this year. But in the near term, the scaling back of interest rate cut expectations has sent bond yields higher. In the current market dynamic, rising bond yields haven't been a welcome sign for stocks.

"We're living in a very bond-driven equity market today," Piper Sandler chief investment strategist Michael Kantrowitz.

And for now, the incoming inflation data is doing little to help on that front.