Hot inflation fuels bets on super-sized July Fed rate hike

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Investors were betting on Wednesday the U.S. Federal Reserve will deliver a super-sized 100 basis point rate hike this month after a mostly grim inflation report showed price pressures, already running at a 40-year high, accelerating further.

“Everything is in play,” Atlanta Fed President Raphael Bostic told reporters in Florida, when asked specifically whether the Fed could go even bigger than the 75-basis-point hike it delivered last month.

A bevy of central bankers over the past couple of weeks had signaled they would support what would be a second straight 75 basis point rate increase at their upcoming policy meeting on July 26-27.

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But after Wednesday data from the Labor Department showed rising costs of gas, food and rent drove the consumer price index (CPI) up 9.1% last month from a year earlier, the view may have changed.

Traders of futures tied to the Fed’s policy rate are now pricing a 70% probability of a full percentage-point rise at the coming meeting, according to an analysis of the contracts by CME Group.

That was up from about a one-in-nine chance seen before the report, which also showed underlying inflation slowing.

But even the slight easing of so-called core inflation, which excludes more volatile food and energy prices, to 5.9% in the 12 months through June from 6.0% in May, was less than economists expected. More worryingly, on a monthly basis, core CPI climbed 0.7% after advancing 0.6% in May, to its highest reading in a year.

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Neither gauge offers comfort to Fed Chair Jerome Powell, who has placed a premium on so-called headline inflation slowing given the outsized impact the cost of gas and food has on typical American households.

Those price pressures are fueling concern that if the Fed does not begin to get inflation in check soon, business and consumer expectations of a torrid rate of future price increases could become entrenched, forcing the Fed to move even more aggressively.

“It really pushes the Fed even further into the corner they’ve been operating in. They need to raise rates quickly and they need to raise rates by large amounts,” said Chris Zaccarelli, chief investment officer at Independent Advisor Alliance. “Unfortunately we were looking for good news and this is not good news.”

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Other central banks are also feeling the heat with the Bank of Canada on Wednesday raising its benchmark interest rate by 100 basis points in a bid to tame soaring inflation, a surprise move and its biggest in nearly 24 years.

Bostic said the latest inflation reading might require officials to consider a 100 basis point increase at its July meeting. While Bostic said he needed to better study the “nuts and bolts” he felt “today’s numbers suggest the trajectory is not moving in a positive way….How much I need to adapt is really tne next question.”

Ahead of its prior meeting in June, the Fed telegraphed a 50 basis point move before pivoting at the last minute to a three quarter point hike on the back of a worse-than-expected inflation report for May, as well as a downbeat consumer inflation expectations survey the same day.

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The persistence of such high inflation and the strength of the central bank’s moves needed to quash it are also once again sharpening fears a recession is on the horizon.

Fed research published this week based on modeling of bond-market yields puts the chance of a recession next year at about 35% if the Fed sticks to its expected baseline rate-hike path, but at 60% if the Fed removes accommodation faster.

“With supply conditions showing little sign of improvement the onus is on the Fed to hit the brakes via higher rates to allow demand to better match supply conditions. The recession threat is rising,” said James Knightley, chief international economist at ING.

The Fed began tightening policy only in March, and has already raised its benchmark overnight lending rate by 1.5 percentage points. Financial markets now predict that rate will reach the 3.5%-3.75% range by year end, higher than Fed policymakers themselves predicted just three weeks ago.

A very tight labor market has so far withstood those swift rate hikes, with unemployment remaining at 3.6%, near a historic low. However, that is seen as a double-edged sword as it also raises concerns that such competition for labor will eventually have to cool to ease inflation. (Reporting by Lindsay Dunsmuir, Ann Saphir and Sinead Carew; Editing by Chizu Nomiyama)