Expectations for the Fed to downsize future rate hikes soar after CPI shows inflation cooled in December

• Investors on Thursday were pricing in a more than 90% chance the Fed will reduce the size of its interest rate hike in February.
• The more bullish view on a potential downshift was sparked by cooler prices in the December inflation report.
• But there are 'lingering pressures' within core inflation for the Fed to consider.

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."