Stubbornly hot US inflation is fuelling bets that the Federal Reserve will become more aggressive about trying to cool price pressures and perhaps ditch its forward guidance by delivering a jumbo-sized interest rate rise in the coming months.
Fed policymakers had already all but promised half-point interest rate rises at their meeting next week and again in late July, following May's half-point increase and the start of balance sheet reductions this month.
That would be more policy tightening in the space of three months than the Fed did in all of 2018.
On Friday, traders of futures tied to the Fed policy rate began pricing in an even bolder path after US Labour Department data showed sharply higher food and record petrol prices pushed the consumer price index (CPI) up 8.6 per cent last month from a year earlier.
A separate University of Michigan survey showed longer-term inflation expectations rising to their highest since 2008.
Prices of Fed funds futures contracts now reflect better-than-even odds of a 75-basis point rate rise by July, with a one-in-four chance of that occurring next week — up from one-in-20 before the inflation report — and a policy rate in at least the 3.25 per cent to 3.5 per cent range at year end.
Yields on the two-year Treasury note, seen as a proxy for the Fed's policy rate, topped 3 per cent for the first time since 2008.
“We believe that today's inflation data — both the CPI and UMich inflation expectations — are game changers that will force the Fed to switch to a higher gear and front-load policy tightening,” wrote Jefferies' Aneta Markowska, who joined economists at Barclays on Friday in forecasting a 75 basis points rate increase at the Fed's June 14 to 15 meeting.
Most economists still expect a half-point rise next week, and more of the same at subsequent meetings through at least September if not further.
Core CPI, which strips out volatile energy and food prices, rose 6 per cent in May, down slightly from April's 6.2 per cent pace but far from the “clear and convincing” sign of cooling price pressures that Fed chairman Jerome Powell has said he needs to see before slowing rate increases.
“Any hopes that the Fed can ease up on the pace of rate hikes after the June and July meetings now seems to be a long shot,” wrote Bankrate chief financial analyst Greg McBride.
Economists at Deutsche Bank concurred, and said they now forecast rates to rise to 4.125 per cent by mid-2023.
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Fed policymakers at the close of next week's meeting will release their own best guesses of how high they will need to lift short-term rates.
They will also provide forecasts of how much unemployment — now at 3.6 per cent — may need to rise before the economy slows enough to reduce inflation.
In recent weeks, some had expressed the hope that by September their own rate rises, along with easing supply chain pressures and an expected shift in household spending away from scarce goods and towards services, would have started to ease price pressures and allowed them to downshift to smaller rate increases.
Friday's inflation report suggested the opposite.
Used car prices, which had been sinking, reversed course and rose 1.8 per cent from the prior month; airline fares rose by 12.6 per cent from the prior month and 37.8 per cent from a year earlier. Prices for shelter rose 5.5 per cent, the biggest jump in more than 30 years.
The Fed's current policy rate target is now 0.75 per cent to 1 per cent. Fed officials want to get it higher without undermining a historically tight labour market and sending the economy into recession, but accelerating inflation will make that a hard task.
“These are ugly numbers … I’d say we’ll probably be in a recession in the fourth quarter of this year with confirmation in the second quarter of 2023,” said Peter Cardillo, chief market economist at Spartan Capital Securities.