Market braces for key inflation report Tuesday that may test the Fed's mettle

• Inflation has become a main worry for the market, but the Fed has worked hard to tamp down those concerns.
• That makes every piece of inflaton data more important, including the March consumer price index, expected Tuesday at 8:30 a.m. ET.
• Headline CPI is expeced to return to the pace it was at in January, 2020, just before the pandemic began to spread across the U.S.

The pace of consumer inflation is likely to have returned to prepandemic levels in March, and it is expected to heat up even more in the next couple of months.

Rising inflation is one of the biggest fears in the market, and if it gets too hot, it could corrode asset values, limit buying power and eat away at corporate margins.

It is inevitable the reopening economy will generate some pick-up in inflation, with demand up sharply and supply chain issues resulting in shortages. Newly vaccinated consumers are also expected to resume traveling and other activities outside the home, which could create a temporary surge in services inflation.

But the Fed and some economists argue this inflationary pick up will be temporary, meaning it should not derail the recovery or result in Fed rate hikes. That makes every new inflation report very important to markets, and that is the case with Tuesday's 8:30 a.m. release of March CPI.

The March consumer price index is expected to show a moderate 0.2% increase in core inflation, excluding food and energy prices, according to economists polled by Dow Jones. On a year-over-year basis, that is a 1.5% pace, compared to 1.3% in February.

March headline inflation is expected to increase by 0.5% or 2.5% year-over-year, up from 1.7% in February. By May, some economists expect headline inflation could be running at an year-over- year rate of 3.5% or more. The headline rate was last at 2.5% in January, 2020.

"We remain positive but once we get to the end of this year and early next year, and we've worked through the supply chain bottlenecks and demand has normalized, as the economy opened up, we don't think it's a sustained source of inflation over the medium term," said Blerina Uruci, senior U.S. economist at Barclays.

Uruci expects core inflation to reach 2.3% by May but then it could be below 2% in the second half of the year.

The Fed has taken great pains to assure markets that it does not expect the inflation trend to remain hot and that the increase is largely the result of base effects. That means the gains in inflation appear larger when compared to the weakness in prices a year ago, when the economy was shutdown.

"I think this year we should be prepared for a lot of volatility in inflation. We'll have those base effects now and we have a little bit of deceleration after that," Uruci said.

The central bank has also altered its inflation policy and says it will tolerate inflation running above its 2% target for a period, before it would raise interest rates.

Fed Chairman Jerome Powell has been driving the message that the Fed is not worried about inflation just yet. He told it to the audience of "60 Minutes" Sunday evening. On an International Monetary Fund panel last week, Powell argued that the U.S. has lived in a period of low inflation for a quarter century and he expects that trend to continue.

"We want to see inflation move up to about 2%. And we mean that on a sustainable basis. We don't mean just tap the base once. But then we'd also like to see it on track to move moderately above 2% for some time. And the reason for that is we want inflation to average 2% over time," Powell said in the "60 Minutes" interview. "Inflation has been below 2%. We want it to be just moderately above 2%. We want it to be just moderately above 2%. So that's what we're looking for. That's the situation we're looking for. And when we get that, that's when we'll raise interest rates."

Fed: Don't be alarmed

Jim Caron, head of global macro strategy at Morgan Stanley Investment Mangement, said the market is now taking its cue from the Fed and that Powell has prepared the markets.

"He gave the market a pregame to see these high inflation prints and not get alarmed. His message to the market is don't be alarmed by it. It's coming back down," said Caron. He said Powell has made it clear that inflation should not be a long-term problem. The Fed has said it wants to keep policy easy to help the economy and the labor market, with millions still unemployed.

"The way we frame this debate is whether we think inflation is unanchored or anchored," said Caron. "I think where Powell is coming down is he's saying it is anchored because it really is just base effects…The way he's coming down on it is by saying there's a lot of slack in the economy."

But then there's the potential for surprises, like on Friday, when March producer price inflation showed a surprise 1% jump, double what was expected. The market took the data in stride, but that may not be the case if the CPI is hotter.

"The CPI will be more relevant for the market," said Peter Boockvar, chief investment strategist at Bleakley Advisory Group. Boockvar expects inflation to be more persistent than the Fed expects, and the market could react to any signs of that.

"Companies are only now beginning to increase prices to offset their own cost pressures," he said.

Uruci said the inflation picture has altered since the pandemic, but she was not surprised by the jump in PPI, as it is consistent with what she is seeing in CPI. "We have really been highlighting the buildup of pipeline price pressures," Uruci said. She said PPI was boosted by two things that would not necessarily show up in problem for consumer inflation. One was a rise in export prices and the other a strong gain in prices of goods sold to the government.

"We expect services to only start picking up in Q3 and Q4. If we're wrong in that forecast ,and that happens sooner, we could see elevated inflation for the rest of the year," she said.

Inside the March CPI, she expects to see a pickup of 0.1% in shelter, which is about a third of the index. Because of the slowdown in rentals, shelter inflation has slowed to about 1.6% from over 3% prepandemic. She said the vaccine news may help lower vacancy rates in some metropolitan areas, lifting rental prices.

The test for the Fed is how March CPI and the next several reports line up.

"Fed officials can utter the word "transitory" until they are blue in the face, but 1) how will they know? and 2) will market participants still get nervous, despite Fed reassurance, when the inflation readings reach levels not seen in a very long time? " wrote Stephen Stanley, chief economist at Amherst Pierpont. "Buckle up, this could be a bumpy ride!"

Stanley made the comment following Friday's PPI report.

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