The consumer price index, which measures how quickly prices are going up in the U.S. economy, rose at a faster than anticipated 2.1 percent in January, compared with a year ago, triggering fears of another rocky run on Wall Street. The Dow Jones industrial average fell more than 100 points at the open, but traders ultimately dismissed the news and the Dow closed up over 250 points.
Inflation around 2 percent is still very low, but Wall Street traders worry that this could be the beginning of a quick run up in wages and prices. There's a big reassessment going on about what the future holds for the U.S. markets and economy.
While no one is talking about an immediate downturn for the economy, the picture looks a lot murkier heading into 2019, causing investors to question whether stocks should be so high. President Trump's tax cuts are widely expected to trigger faster growth and more inflation this year, which could backfire if the economy gets too hot.
The monthly Labor Department report Wednesday showed prices were rising for just about everything: gas, rent, clothes, medical care and food. Americans are especially paying more at the pump, with gas prices jumping 8.5 percent in the past year and transportation rising 4 percent.
“The data raise the already high likelihood that the Fed will be lifting rates again next month, unless turmoil in the financial markets increases significantly,” said Jim O'Sullivan, chief U.S. economist at High Frequency Economics.
The Federal Reserve, under the new leadership of President Trump's appointee, Jerome H. Powell, is on track to increase interest rates three times in 2018. But if inflation continues to pick up, investors say the Fed might have to hike four times this year. Wall Street predicts nearly an 80 percent chance of a rate increase in March.
“We will remain alert to any developing risks to financial stability,” Powell said Tuesday at his formal swearing in ceremony as Fed chair.
Many traders read that as a signal that Powell is closely watching the stock market swings. Earlier this month, the Dow fell more than 1,000 points in a single day. The trigger was a Labor Department report showing that wages grew at a better-than-expected pace in January. Now another key gauge of inflation — CPI — is showing a similar upward trend.
“There's a risk that this could pour fuel on the fire of last week's market sell off,” said Luke Bartholomew, a strategist at Aberdeen Standard Investments. “That nervousness is not going away.”
In a worst-case scenario, consumers and businesses might start pulling back on spending as they see prices rise rapidly in coming months (or years). On top of that, the Fed typically responds to higher inflation by boosting interest rates, ending the easy money days that have fueled a nine-year stock market boom.
In recent years, investors put their money in riskier stocks since they were earning so little in interest at the bank or from bonds. But if inflation returns in force and the Fed raises interest rates, it could cause Wall Street to redo the playbook.
“Stock market valuations are high. People are on edge and looking for an excuse to sell,” said Chris Zaccarelli, chief investment officer of Independent Advisor Alliance. “The fact that interest rates could move up so quickly is a legitimate reason for the market to get spooked.”
Former Fed chairman Alan Greenspan is worried that investors might exit both stocks and bonds as rates rise.
“I would argue there is both a stock market and a bond market bubble,” Greenspan said Wednesday at a talk at the American Enterprise Institute.
Bond yields jumped to 2.9 percent after the hot inflation report, triggering negative opening for the stock market. As bond yields rise and the Fed lifts rates, companies and individuals also tend to borrow less, another potential damper on the economy.
Still, some economists say it might be an overreaction to read much into this report. Inflation remains low and it's mostly being driven by rising oil and gas prices right now, which is not unexpected after gas prices were so low in 2016.
“We expect core inflation to rise this year, but we don't view this report alone as definitive evidence that the trend is rising,” O'Sullivan said.