Consumer prices in the United States accelerated more than expected in January. The annual inflation rate hit a new record high unseen in 40 years, urging the Federal Reserve to take a more aggressive stance on monetary policy and interest rates. We will discuss interest rates and whether there are reasons to worry about rising US inflation right after we analyze the results of the US Labor Department report.

So, the report logged an increase in the consumer price index to 7.5% y/y versus a 7% rise in December 2021. In January, inflation grew 0.6% compared to the previous months, revealing a surge in food, energy, and housing costs. The core inflation rate, excluding food, energy, alcohol, and tobacco, jumped 6% from a year earlier in January. It was the largest annual increase in core consumer prices since 1982. The index climbed 0.6% from December.

In this light, bond yields and the US dollar added gains. The S&P 500 traded lower but then recouped all losses. Economists had expected the consumer price index to accelerate to 7.3% y/y, up by 0.4% from December 2021.

Federal Reserve keeps abreast

The US Federal Reserve seems to have expected such an outturn of events. Cleveland Federal Reserve President Loretta Mester sounded extremely hawkish on Wednesday. Apparently, it is her duty to prepare the market and investors for future changes in monetary policy. Mester laid out an aggressive plan for reducing easy-money policies this year, saying the central bank will be ready to hike rates at any meeting and should be looking at shedding mortgage-backed securities it is holding. "Each meeting is going to be in play," Mester said at a virtual event hosted by the European Economics and Financial Centre. "We're going to assess conditions, we're going to assess how the economy's evolving, we're going to be looking at the risks, and we're going to be removing accommodation." Mester sees a March hike but does not expect the rate to be raised by more than 25 basis points. She also emphasized that it is time for the central bank to start reversing the historically accommodative measures it took during the Covid pandemic crisis.

Yesterday's inflation report again confirms the regulator's intention to hike rates next month. The question is how aggressive the Federal Reserve's stance could be. The fact is that continuing inflation has undermined recent wage growth and reduced the purchasing power of American households. Dissatisfaction with the current state of affairs in the country will only grow, which will surely harm US President Joe Biden and his political career.

By the FOMC meeting, scheduled for March 15-16, policymakers will already have data on the February CPI and employment. This will help the regulator reduce market volatility and act more subtly towards monetary policy changes.

Investors have raised their expectations for a federal funds rate hike by half a point. However, many economists see a more gradual approach to increasing borrowing costs.

No doubt, the unexpected rise in the consumer price index in January is a convincing argument in favor of a 50 basis point rate hike at the FOMC meeting in March. However, February results will help determine the next move more accurately. Rising inflation has affected energy prices, food, and rent. Some economists are worried about rising health care prices, which have more weight in the PCE deflator, the Fed's preferred indicator.

Surging inflation is associated with an imbalance in supply and demand. With the massive government stimulus seen in recent years, an increase in household purchases had disrupted global supply chains already hit by the coronavirus pandemic. High competition for skilled workers in the US labor market, which has reached its pre-pandemic levels, is forcing employers to raise wages in an attempt to fill vacancies. As a result, inflationary pressures only build up. Higher wages lead to an increase in production costs to offset employment costs. Last year, worker compensation costs grew the highest in two decades.

Despite this fact, wage growth cannot keep up with inflation. In January, hourly wages dropped by 1.7% from a year earlier, marking its 10th consecutive decrease.

Food prices jumped 0.9% in January, the highest in three months. Energy prices also surged 0.9%. Household energy costs hit the 16-year high last month.

Interest rates

Speaking of interest rates, the situation is more difficult. Mounting inflationary pressure made markets review outlooks. Consequently, the Federal Reserve is now expected to raise interest rates at every meeting, including in July. This could lead to an increase in borrowings to 1.0% by the summer, which is equivalent to a traditional quarter-point move in each of the next four meetings. Six such rate hikes could take place this year.

Some experts believe that the regulator will announce a 50 basis points rate hike in March. The fact that monetary policy is lagging may force the central bank to act more aggressively.

Are there reasons to worry about US inflation in the short term?

No doubt, inflation is accelerating mainly due to the effects of the coronavirus pandemic. Overall, the US economy demonstrates good-enough performance, so the return of prices in an acceptable range is just a matter of time. Many experts, as well as the bond market, suggest that inflation is approaching its peak. This is quite possible that the peak of inflation will be recorded in January 2022. Consumer prices are forecast to slow down to 4.8% by the end of the year and tumble to 2.4% by 2023. Inflation expectations of the bond market lowered in recent months. In the long term, inflation is suggested to reach the Federal Reserve's target level.

Technical analysis of EUR/USD

The euro went down after US inflation data had been released. Bulls managed to protect support around 1.1400. Consequently, demand for risk assets increased and the bullish market resumed. Consolidation above 1.1480 will allow the instrument to approach the area of new highs: 1.1520 and 1.1560. The volume of long positions will increase near 1.1444, this week's key resistance, if the price goes down. In case of a breakout of this barrier, the price will fall to 1.1405 and bulls will start active purchases.

Technical analysis of GBP/USD

GBP bulls broke above 1.3610. They need to prove their presence at this level after a correction, expected in the first half of the day. If the quote fails to break below the mark, the bull market will continue and the price will head towards the highs of 1.3680 and 1.3740. If it goes below 1.3610, pressure on the trading instrument will increase. In this case, we can expect a corrective move to 1.3530 and 1.3490.