Fed seen slowing rate hike pace as inflation eases

© Reuters. FILE PHOTO: An eagle tops the U.S. Federal Reserve building's facade in Washington, July 31, 2013. REUTERS/Jonathan Ernst/File Photo

By Ann Saphir and Howard Schneider

(Reuters) - A larger than expected drop in consumer inflation last month will likely prompt the Federal Reserve to pare down future interest rate increases as the impact of its swift monetary tightening this year begins to take hold.

October data published Thursday by the Labor Department showed key items like rents increasing less than expected, while the price index for used cars - a culprit in the initial, pandemic-related surge in inflation - declined by 2.4%, the fourth consecutive monthly drop. Prices for airfares, medical services, and apparel all declined.

Though overall inflation remained high by historic standards, with prices increasing 7.7% from a year earlier, the monthly pace of "core" inflation that excludes volatile food and energy costs dropped by half, to 0.3% in October from 0.6% the month before.

Some analysts said this may just be the start of inflation being defused after emerging last year as a chief risk to the economy.

"This is not some kind of outlier," wrote Omair Sharif of Inflation Insights. "This is the start...of lower prints."

The report sent U.S. stocks soaring, with the S&P 500 up more than 4% in late morning trading on hopes the Fed, while not expected to turn dovish any time soon, may at least not be forced into a more aggressive posture.

The yield on the 2-year U.S. Treasury note, the maturity most sensitive to Fed rate expectations, dropped by nearly 20 basis points, the most in one day since June. Traders in futures contracts tied to the Fed's benchmark rate show investors now expect the blistering pace of policy tightening to slow next month - and for the Fed to stop its rate hikes sooner than expected.

After raising rates more sharply this year than at any time since the 1980s, including four straight 75-basis-point rate hikes that brought the policy rate to a 3.75%-4% range as of last week, the Fed is now seen shifting to a half-point rate hike next month and quarter-point hikes after that. Rate futures contracts are now pricing in a top policy rate in the 4.75%-5% range next March -- lower than the 5%-plus range seen before the report -- and interest-rate cuts in the second half of the year.

Fed policymakers took some relief from the data but, in an era when their initially sanguine view of inflation left them playing catch-up, also said the fight with rising prices is far from over.

"This morning’s CPI data were a welcome relief, but there is still a long way to go," new Dallas Fed President Lorie Logan said. "While I believe it may soon be appropriate to slow the pace of rate increases so we can better assess how financial and economic conditions are evolving, I also believe a slower pace should not be taken to represent easier policy."

Fed officials have said they want convincing evidence that inflation is in decline before altering their approach, and still believe returning inflation to their 2% target will require keeping rates at a "restrictive" level for a potentially extended period of time.

Continued high inflation for services, possibly reflecting labor markets that remain tight for those more labor-intensive businesses, could prevent any quick resolution of the overall inflation problem.

GRAPHIC: Rates and inflation - https://graphics.reuters.com/USA-FED/INFLATION/gkvlgnaywpb/chart.png

But the central bank at its last meeting also indicated it could take a step back from delivering interest rate hikes in such large chunks in favor of a more tempered approach as the economy adjusts to the "lagged" impact of monetary policy.

"The hikes in interest rates are beginning to bite into the economy and lower inflation as consumers become more frugal,” said Peter Cardillo, chief market economist at Spartan Capital Securities.

Speaking after the report, Philadelphia Fed president Patrick Harker indicated his support for slowing rate hikes and then stopping, perhaps even earlier than markets now expect.

"I am in the camp of wanting to get to what would clearly be a restrictive stance (with the policy rate) somewhere north of four-ish, you know, four and a half percent, and then I would be okay with taking a brief pause, seeing how things are moving," he said.