Inflation beats expectations, traders begin betting on a Fed rate hike in December: 51% probability

According to CNBC, influenced by both the April consumer and producer price indexes hitting multi-year highs, the federal funds futures market on 5/15 for the first time priced the FED’s next move as “rate hikes” rather than rate cuts. Based on the CME FedWatch tool, the probability of a rate hike at the December FOMC is about 51%; it rises to about 60% in January and reaches 71% in March. This week, newly appointed Fed chair Warsh took office; he previously said that under the current environment the central bank can still cut rates, contrasting with the market’s latest expectations.

FedWatch: 51% for a December rate hike, 71% for March

CME FedWatch reflects rate expectations using 30-day federal funds futures prices. The 5/15 data show that for the first time in this cycle, the market lists “rate hikes” as the baseline scenario: the probability of a December FOMC rate hike is about 51%, rises to around 60% in January, and reaches 71% in March.

By comparison, the last time there were consecutive expectations for rate hikes traces back to 2022, when the FED raised rates four consecutive times by 3 percentage points to curb inflation. At that time, the cycle flipped from expectations of rate cuts to consecutive rate hikes, similar to the direction of market pricing this week.

Besides April CPI at 3.8%, PPI and import/export prices rise in tandem

This week, April CPI increased 3.8% year over year, hitting a 32-month high. The producer price index (PPI) also broke above multi-year highs, while import and export price indexes returned to the level of the prior inflation peak. The Survey of Professional Forecasters released by the Federal Reserve Bank of Philadelphia shows that the second-quarter inflation forecast was revised upward significantly from the prior survey, with it potentially reaching as high as 6%.

The simultaneous rise in three inflation data points was the direct trigger for this reversal in expectations. CNBC cited a report saying that current price momentum has gone beyond the FED’s past framework for interpreting “transitional inflation.”

Warsh took office amid the expectation reversal; 3 votes against rate cuts already within the FOMC

Former FED governor Kevin Warsh officially took over as Fed chair on 5/15. He had previously publicly said that under the current environment the central bank can still cut rates, opposite to the direction of the market’s latest bets. Warsh passed in the Senate with a 54-45 vote, one of the most divisive votes in history.

At the prior FOMC meeting, three members had already cast dissenting votes. The dissenting language hinted at wording “for the next move to be rate cuts,” showing that disagreements within the FED about inflation persistence surfaced earlier than the market.

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