Signs of further cooling in inflation in December spurred bullish expectations Thursday that the Federal Reserve will reduce the size of its upcoming interest-rate hikes.
Fed funds futures showed a 93.2% probability of a rate increase of 25 basis points for the decision due February 1, soaring from 76.7% a day earlier, according to the CME FedWatch tool.
If the Federal Open Market Committee were to follow through on that view, the central bank would drive its benchmark rate to a range of 4.5%-4.75%. A rate hike of 25 basis points would be the smallest since the Fed, led by Chair Jerome Powell, began running borrowing rates up in March 2022, by a quarter-percentage point.
The December CPI report reinforces the trend of a declining rate of inflation, Yung-Yu Ma, chief investment strategist at BMO Wealth Management, said in a Thursday note.
"Most importantly, this is happening with a labor market that remains healthy," Ma wrote. "This should soften the Fed's tone at the next meeting, and it reinforces our belief in a soft landing in which inflation falls but the labor market remains healthy and the economy recalibrates to higher interest rates in the coming quarters."
Investors also chopped down expectations for a March 22 rate hike of 50 basis points, to 5.4% from 18.6%.
The final CPI report for 2022 showed December headline inflation fell 0.1% month over month, meeting the consensus estimate from a Bloomberg survey of economists. The headline rate of 6.5% year over year was lower than 7.1% in November.
Core CPI that excludes energy and food prices rose 0.3%, meeting expectations but it was slightly higher than 0.2% in November.
"The CPI report was in line with consensus, but the details paint a picture of lingering pressures at the core," Jefferies economists Aneta Markowska and Thomas Simons wrote in a note.
They noted core services rose by 0.5%, up from 0.4% in November, with recent weakness in rental prices not yet feeding through to the CPI. Core services excluding housing rose monthly by 0.3% following a 0.1% increase.
"We think that today's report keeps a 50 basis points hike on the table for the next FOMC meeting, though it is by no means a high conviction call," said Jefferies. "Regardless of the size of the next hike, we expect the FOMC to get to 5.1%, the only question is whether we get there in March or May."