The Fed remains too sanguine on inflation, and markets too complacent, economist Neil Dutta warns
The Fed may be too optimistic about the outlook for inflation.
Investors who are inclined to catastrophize already have plenty of potential pitfalls to fixate on these days.
Neil Dutta, head of economics at Renaissance Macro Research, added one more to the list on Tuesday: While doubts about the durability of the artificial-intelligence trade remain front and center for investors, the risk that the Federal Reserve will go too far in its quest to quash inflation is becoming an increasingly serious threat to the stock market heading into 2027.
"I definitely think that overtightening is a big risk," Dutta told MarketWatch on Tuesday. "You're in this zone where the unemployment rate is going down, the labor market is firming and inflation is moving further away from the Fed's target."
Federal Reserve governor Christopher Waller surprised investors early Tuesday when he suggested during a speech in London that the central bank might need to get even more aggressive if it hoped to drive inflation back to its 2% target.
"[I]f the October CPI inflation data out later today are similar to the past two monthly readings - with core CPI inflation around 0.3 percent or even higher - then a stronger policy move may be needed," Waller said in his prepared remarks. "In that case, I believe a 50-basis-point hike in the policy rate should be considered at the December meeting."
Shortly afterward, October core CPI came in at 0.3%, sending bond yields surging and stock futures tumbling into the red.
Too sanguine on inflation
Because they generally increase the cost of borrowing money, Fed rate hikes are considered a threat to valuations in the stock market.
The extent to which Waller's views are shared by his fellow governors remains to be seen, Dutta said. But the official data, including Tuesday's consumer-price index report, suggest that rates are still too low to have much of an impact on prices.
While crude-oil prices have come down since the midterm elections, prices of refined products like diesel remain high. Meanwhile, signs that housing costs are beginning to accelerate have started to emerge, another unwelcome development for investors and consumers alike.
October inflation numbers released on Tuesday hinted at a troubling reacceleration in the cost of rental housing, Dutta said in commentary shared with clients on Tuesday. If housing-price growth doesn't slow, it will be hard for inflation to get back down to the Fed's 2% target.
"In short, the Fed remains too sanguine on inflation and markets too complacent on the extent of policy tightening required," Dutta wrote in the report, which was shared with MarketWatch.
The bond market was already adding to the pressure facing the central bank. The 2-year Treasury yield BX:TMUBMUSD02Y was up 18 basis points in recent trading Tuesday - on track for its biggest one-day jump since April 9, 2025, Dow Jones Market Data showed.
The widening gap between the 2-year rate and the Fed's policy rate is one way bond investors are signaling to the central bank that it is expecting more aggressive rate hikes ahead.
Currently, investors expect that the Fed will raise interest rates by another 50 basis points in the months to come, in line with the latest forecasts from senior Fed officials released in September. That would reverse the 75 basis points in "insurance cuts" that the central bank pushed through in 2025. But given how things are trending, it might not be enough.
"Taking back the insurance cuts of last year is the bare minimum right now," Dutta wrote.
U.S. stocks were heading lower on Tuesday, with the S&P 500 SPX down 0.5% at 7,509, while the tech-heavy Nasdaq Composite COMP was off by 1% at 24,991, FactSet data showed. The Dow Jones Industrial Average DJIA was off by 170 points, or 0.3%, at 52,216.
-Joseph Adinolfi
