Further Fed hikes expected after data dashes 'disinflation' hopes

By Michael S. Derby and Ann Saphir

NEW YORK/SAN FRANCISCO (Reuters) -Expectations that the U.S. Federal Reserve will need to push interest rates higher and keep them elevated longer than previously projected rose on Friday after data showed a key inflation gauge accelerated last month.

Even so, Fed policymakers speaking on Friday did not push for a return to the kind of aggressive action that marked last year's interest-rate hikes, suggesting that for now central bankers are content to stick to a gradual tightening path despite signs that inflation is not cooling as they had hoped.

The Commerce Department reported that the Personal Consumption Expenditures price index, the metric by which the Fed measures its 2% inflation target, rose 5.4% last month from a year earlier, a pickup from an upwardly revised 5.3% annual pace in December.

Underlying "core" inflation climbed a faster-than-expected 4.7% from a year earlier, compared to December's upwardly revised 4.6% pace.

The report "is another indication that the impulse of inflation and price pressures is still with us," Cleveland Fed President Loretta Mester told Reuters on the sidelines of a conference in New York. "It's going to take more effort on the part of the Fed to get inflation on that sustainable downward path to 2%."

Even so, Mester -- who had wanted a half-point hike at the Fed's last meeting -- said she could not yet say if she would support such a large hike at the Fed's upcoming meeting.

She is among the minority of Fed policymakers who in December thought they would need to lift the policy rate to 5.4% to stop inflation, while most believed 5.1% would suffice. Earlier on Friday she said she had not revised her view.

Similarly, none of the other Fed policymakers who spoke on Friday, including the normally hawkish Governor Christopher Waller and St. Louis Fed President James Bullard, focused on the fresh inflation data to argue for a more muscular Fed response. Boston Fed President Susan Collins said more rate hikes will be needed, but did not specify a particular stopping point.

Implied yields on federal funds futures contracts rose on Friday as traders firmed up expectations for at least three more rate hikes through June, a path that would push the U.S. central bank's benchmark overnight interest rate to the 5.25%-5.50% range, from the current 4.50%-4.75% range.

Pricing also now puts about a 40% chance of an even higher stopping point for that rate, up from about 30% prior to the release of the PCE data.

And traders largely erased what had been consistent bets on Fed rate cuts toward the end of the year, pricing in a year-end Fed policy rate of 5.26%.

"There are inflationary pressures in the economy, the level of inflation is still too high, and it's going to take more on the monetary policy side to get inflation down, Mester said.

Economic data in recent weeks has generally come in stronger than expected, with job growth still robust and wage gains exceeding what Fed Governor Phillip Jefferson said on Friday was consistent with a timely return to 2% inflation.

Revisions to data from prior months in Friday's Commerce Department report showed inflation did not cool in November and December as much as had been thought, and spending in January rose more than expected even as the savings rate increased.

All told, the economic readings may throw doubt on Fed Chair Jerome Powell's assessment this month that the "disinflationary process" had begun, a view that seemed to justify the central bank's decision at its Jan. 31-Feb. 1 policy meeting to deliver a quarter-percentage-point rate increase after a string of bigger hikes in 2022.

"If the Fed had this data at the last meeting, they probably would've raised by 50 (basis points) and the tone from the press conference would've been a lot different," said Gene Goldman, chief investment officer at Cetera Investment Management.

Goldman said he expects the next round of Fed projections, to be published in March, to signal rates will rise father and stay there longer than previously thought.

"It looks like the Fed will have to be more aggressive," said Yelena Shulyatyeva, an economist at BNP Paribas. "They will probably overdo it, in our view, and that will eventually lead to a recession; the question is more like when, not whether, it will be a recession."

(Reporting by Sinead Carew, Lindsay Dunsmuir and Howard Schneider; Writing by Ann Saphir; Editing by Paul Simao, Andrea Ricci and Will Dunham)