Before the FOMC’s January meeting, many economists believed that the US Fed would pause its interest rate hikes after a 25-basis point hike. However, amid strong economic data and high inflation, many are now tempering their expectations.

The Fed raised rates by 25 basis points on February 1 which was in line with expectations. Also, Fed chair Jerome Powell said, “We can now say I think for the first time that the disinflationary process has started.”

It was the first time in the current tightening cycle that Powell used “disinflation” while mentioning price rise. He reiterated similar views at an event last week in Washington.

Powell said, “The disinflationary process, the process of getting inflation down, has begun and it’s begun in the goods sector, which is about a quarter of our economy.” He however cautioned, “But it has a long way to go. These are the very early stages.”

Importantly, Powell added that the Fed would “react to the data.” Notably, the US economy added 517,000 new jobs in January which was over twice what the market expected.

Powell said that the report was “certainly strong—stronger than anyone I know expected.” He added, “It kind of shows you why we think this will be a process that takes a significant period of time.”

Fed Interest Rate Probability Rises after Strong Economic Data

Along with the strong January jobs report, the retail sales data for the month also surprised on the upside. US retail sales increased by 3% in January which surpassed analysts’ estimate of 1.9%.

Bill Adams, chief economist for Comerica Bank said, “The monthly reports on industrial production, retail sales, and jobs were generally better than expected and point to a pickup in economic activity in early 2023 after a soft patch in late 2022. The Fed will read recent activity reports as supporting plans for additional interest rate increases in the first half of this year.”

Notably, the dot plot calls for another 50-basis point rate hike in 2023.

US Inflation Data Was Higher Than Expected in January

While the January economic data mostly came in ahead of expectations, the inflation data was also hotter than expected. The CPI rose 0.5% on a monthly basis in January. The annualized inflation came in at 6.4% which was higher than the 6.1% that markets were expecting.

Also, the Labor Department upwardly revised December CPI to show that the metric rose 0.1% monthly instead of the 0.1% fall. The Department has adjusted the weights of goods and services which warranted a revision of data.

The core CPI, which excludes the volatile food and energy prices rose 5.6% annualized in January, which was ahead of the 5.5% that analysts were expecting.

Many economists believe that the Fed has a tough road ahead as it tries to bring inflation towards its targeted 2%. Mohamed El-Erian, Chief Economic Advisor at Allianz has warned that prices of some goods are going up again. He also said that services inflation would stay higher for much longer.

Notably, higher wages and rents have been weighing heavy on services inflation. High inflation and the resultant rate hikes took a toll on risk assets last year. However, some investment strategies can outperform during high inflation.

Morgan Stanley Sees More Rate Hikes by the Fed

After recent economic data showed that the Fed is still far away from taming inflation, traders now see a hawkish Fed this year. Several economists have also raised their projected terminal rates.

In a note, Morgan Stanley said that its economists now see two more rate hikes of 25 basis points this year.

Referring to the January nonfarm payroll data, Morgan Stanley said, “When it comes to economic data releases, there are surprises and then there are shockers. The U.S. employment report for January, which came out earlier this month, was clearly in the latter category.”

Meanwhile, there is a section of the market that believes that we are headed for deflation instead.

Some See a Deflation on the Horizon

Cathie Wood, Jeffrey Gundlach, and Elon Musk are among those who believe that the Fed has gone too far with its rate hikes.

Musk has on multiple occasions predicted a recession and said that Fed is only going to make it worse with its rate hikes. Fed’s rate hikes, recession fears, and the fallout of FTX bankruptcy have also taken a toll on digital assets. We have a guide on whether crypto is recession-proof.

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