TD: Fed Likely to Hold Rates Steady Despite Higher CPI, Rate Cuts Pushed to Q3

The latest Consumer Price Index (CPI) report has introduced renewed concerns about inflationary pressures, leading many investors to recalibrate their expectations for the Federal Reserve’s monetary policy trajectory.

While the higher-than-expected inflation reading has raised questions about the timing of rate cuts, TD economists maintain that the report should not be interpreted as a definitive signal of sustained inflation. Instead, they argue that the Federal Reserve will remain in a holding pattern, opting to wait for additional data before making any policy shifts.

The broader market response suggests that while inflation remains a challenge, expectations for rate cuts have simply been delayed rather than eliminated altogether. This article examines the implications of the CPI report, the Federal Reserve’s potential response, and what investors should anticipate in the coming months.

CPI Report: A Temporary Setback or a Structural Issue?

The latest CPI data revealed an increase of 0.5% for January, exceeding expectations and lifting the annual inflation rate to 3.0% from 2.9% in December. Core CPI, which excludes volatile food and energy prices, also came in higher than forecast at 3.3% year-over-year. This suggests that underlying price pressures remain persistent, which could complicate the Federal Reserve’s plans to ease monetary policy later this year.

However, TD economists caution against overinterpreting the data. January inflation reports often reflect seasonal distortions, and similar patterns were observed in previous years. Additionally, while the month-over-month figures were elevated, broader disinflationary trends remain intact, especially as consumer demand cools and supply-side constraints ease.

Federal Reserve's Likely Response: Holding the Line

Given this inflation surprise, the Federal Reserve is expected to remain cautious, avoiding any immediate commitments to policy easing. The Fed has consistently emphasized its data-dependent approach, requiring sustained evidence that inflation is moving toward its 2% target before cutting rates.

TD economists continue to anticipate that rate cuts will begin in the third quarter of 2025. This timeline aligns with the Fed’s stated preference for ensuring inflation is sustainably on a downward trajectory before adjusting monetary policy. The central bank is also balancing multiple factors, including employment levels, financial stability, and global economic risks.

Despite the inflation spike, Fed officials have made it clear that they do not intend to overreact to individual data points. In his recent testimony, Chair Jerome Powell reiterated that the central bank remains committed to its dual mandate of price stability and maximum employment. Powell also stressed that while the inflation data was disappointing, one report alone is not sufficient to shift the Fed’s broader policy outlook.

Market Reaction: Repricing Rate Cut Expectations

The immediate response to the CPI report was a sharp jump in Treasury yields, reflecting growing skepticism that the Fed will cut rates in the near term. The 10-year Treasury yield climbed to 4.64%, while the 2-year yield surged to 4.37%, both reflecting investor reassessments of monetary policy expectations.

Futures markets, which previously priced in the likelihood of a rate cut as early as June, have now pushed back expectations to September. Market-based probability models suggest that traders are now assigning a lower likelihood to multiple cuts this year, with some questioning whether the Fed might even delay easing into 2026 if inflation remains sticky.

Equity markets reacted with initial weakness, particularly in interest rate-sensitive sectors such as technology and real estate. However, the losses were mitigated by strong earnings results from major companies, suggesting that corporate fundamentals remain robust despite ongoing macroeconomic uncertainty.

Implications for Investors and the Broader Economy

For investors, the shifting rate cut expectations reinforce the need for a diversified approach to asset allocation. The market’s enthusiasm for aggressive monetary easing appears to have been premature, meaning sectors that had rallied on hopes of lower rates—such as high-growth technology stocks—could face continued volatility.

Conversely, financials and energy stocks, which typically benefit from a higher rate environment, may see stronger performance in the near term. Additionally, fixed-income investors should prepare for continued fluctuations in bond yields as markets adjust to evolving Fed policy expectations.

On the economic front, the delay in rate cuts could translate into prolonged higher borrowing costs for consumers and businesses. Mortgage rates, which had begun to decline in anticipation of Fed easing, may remain elevated for longer. This could dampen housing market activity, particularly for first-time buyers who were hoping for lower financing costs.

Similarly, businesses reliant on debt financing may face higher capital costs, potentially slowing investment and expansion plans. However, a resilient labor market and steady consumer spending suggest that the broader economy remains on solid footing despite these challenges.

Looking Ahead: Key Data to Watch

The Federal Reserve’s decision-making process will be guided by incoming economic data, with several key reports likely to shape market expectations in the coming months:

- Personal Consumption Expenditures (PCE) Price Index (February 28, 2025): The Fed’s preferred inflation gauge will provide further insights into underlying price pressures.

- March CPI Report (April 10, 2025): Another high CPI reading could further delay rate cut expectations, while a softer report could reassure markets.

- FOMC Meetings (March 19-20, 2025 & June 11-12, 2025): The Fed’s updated economic projections and Powell’s commentary will be crucial in assessing the timing of any policy changes.

Conclusion: A Delayed But Not Derailed Easing Cycle

While the latest CPI report has pushed back expectations for Federal Reserve rate cuts, it does not signal a fundamental shift in the overall disinflationary trend. TD economists maintain that the Fed will hold rates steady in the near term while preserving its easing bias, ultimately beginning rate cuts in the third quarter of 2025.

For investors, this means continued market volatility as traders adjust their expectations to the Fed’s evolving stance. Interest rate-sensitive sectors may face pressure, while financials and energy stocks could benefit from a higher-for-longer rate environment.

Ultimately, the Fed’s patient approach reflects its commitment to ensuring inflation is fully under control before shifting to an easing cycle. While markets may have to wait longer than initially expected for rate cuts, the central bank’s cautious stance is aimed at avoiding premature policy adjustments that could reignite inflationary pressures.