Federal Reserve finds new hope even as its worst nightmare is happening

The Federal Reserve is staring down a nightmare it can’t escape, and the numbers prove it. Inflation is heating up again, and the proof is in the latest data from the Institute of Supply Management (ISM). Prices paid by purchasing managers have soared to a 22-month high.

The last time they hit this level, back in February 2023, inflation in the U.S. was burning at over 6%. Now, the Fed is scrambling to figure out how to deal with what looks like a fresh wave of trouble.

This data hit the market like a hammer on Tuesday at exactly 10 a.m. ET. Within five hours, the S&P 500 tanked more than 100 points, wiping out $650 billion in market cap.

For casual observers, it might’ve looked random, but the pros knew better. They saw the writing on the wall: any hope for near-term rate cuts just vanished into thin air.

Inflation strikes back, the market crumbles

Two days before the chaos, ISM dropped its PMI report, a key barometer for where inflation is headed. It showed that prices paid in the services sector have skyrocketed to their highest since early 2023.

This indicator is one of the strongest predictors of what happens to the Consumer Price Index (CPI). And the takeaway is clear: inflation is alive and well.

The consequences were swift. The market mood changed like a stampede, with investors rushing to adjust positions. Meanwhile, gold defied every expectation by surging past $2,700 an ounce, even as the U.S. dollar strengthened to multi-year highs.

This shouldn’t happen. Typically, high yields and a strong dollar crush gold. But inflation has its own rules. Over the past year, gold prices have jumped 32%, while 10-year Treasury yields hover at 4.70%.

Federal Reserve Chair Jerome Powell and his team are now clinging to an alternative measure of inflation: the “market-based” metric. Unlike the traditional numbers, which surged to 2.8% in November, this measure has stayed flat at 2.4% since May.

It excludes data based on estimates—like housing services or non-market services—and focuses only on prices that can be directly observed. This makes it a rare bright spot for the Fed, but not everyone is convinced.

Fed faces tough choices as data piles up

Fed Governor Christopher Waller leaned on the market-based inflation metric during his speech on Wednesday, calling it a better reflection of the economy’s reality. He argued that traditional inflation metrics are skewed by things like housing costs, which rely on estimates.

“Inflation in 2024 has largely been driven by increases in imputed prices,” Waller said, explaining why he sees this data as unreliable. His position has gained traction within the Fed, with minutes from the latest meeting showing broad agreement among policymakers.

This market-based version of the personal consumption expenditures (PCE) price index filters out noise from categories that don’t provide direct price observations. It excludes services like portfolio management fees, which track stock prices, and insurance costs.

Both categories have contributed to inflated numbers in recent months, thanks to rising equity markets. By ignoring these variables, the Fed sees a less chaotic picture.

But not everyone in the camp is ready to celebrate. Philadelphia Fed President Patrick Harker admitted that inflation is taking longer than expected to hit the central bank’s 2% target.

Speaking in Princeton, New Jersey, on Thursday, he said the process has been uneven, even as the labour market cools and the broader economy holds strong. “I still see us on a downward policy rate path,” Harker said, while warning that any moves will depend entirely on incoming data.