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How will the February's CPI Report Affect the Fed's Decision on Interest Rates?

After a tumultuous week with the failure of SVB, Silvergate, and First Republic, the banking system generated a general panic that dramatically affected financial markets; finally, some good news this Tuesday for financial markets was given. The CPI reports for February finally came out and the results seem very promising. Inflation has been heading downward since June 2022. In mid-2022, inflation was at 9%. The latest CPI reports released by the U.S. Bureau of Labor Statistics show that inflation was brought down to 6%. As a result, stocks bounced back, with the Dow Jones Industrial Average up more than 300 points in early trading. Treasury yield, which plummeted Monday amid fears over the banking industry’s health, rebounded solidly, pushing the policy-sensitive 2-year note up 30-basis points to 4.33%.

Source: U.S. Bureau of Labor Statistics

According to the U.S. Bureau of Labor Statistics, the CPI rose 0.4% in February on a seasonally adjusted basis, after increasing 0.5% in January. The index for shelter was the largest contributor to the monthly all-items increase, accounting for over 70 percent of the increase, with the indexes for food, recreation, and household furnishing and operations also contributing. Inflation is clearly on the decline, and this shows to some extent that the federal reserve’s policy of raising interest rates is working. But it remains a painful approach to solving the inflationary crisis. Inflation is a difficult thing to quantify and efforts to do so can never be entirely accurate. 6% remains a high percentage to bear even though it is declining.

U.S. stocks surged following the release of the data, and Treasury yields moved higher. This may affect the Federal Reserve’s forthcoming meeting on interest rates. We are almost 100% certain that the Federal Reserve will continue raising interest rates, but to what extent? When Jerome Powell gave his testimony to Congress last week, the financial world anticipated that the Feds would hike rates by a 0.50-basis point. Now that inflation is declining, the Feds may potentially reconsider the basis points on which it wants to increase interest rates. If rates are maintained at 0.25-basis points, we can then expect inflation to decline between 5.75% and 5.5%, which is a satisfactory outcome. If rates, however, are increased by 0.50-basis points, then inflation may decline by a whole percent, thus to 5%. If inflation declines to 5% based on the premise that interest rates were hiked by a 0.50-basis point, then this March-22 meeting could be the last meeting on increasing interest rates. If inflation declines to 5.75% or 5.5%, then the Federal Reserve will have to keep increasing rates. Thus what will be the best trade-off to tame inflation?

As painful as the 0.50-basis point increase will be, it is the logical trade-off to go with because this will be a one-time deal that consumers and investors will have to face before the economy can be relieved for a long time. As inflation remains on the decline, wages need to increase, on the other hand, for the economy to be back into equilibrium. The Federal Reserve will need to reduce the quantity of the money supply, and investment should be made into wealth creation rather than into liquidity.


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