From the Desk of AgFi’s Business Strategist Published 2/16/26 – On Friday, the Consumer Price Index (CPI) was issued showing that inflation was milder than expected. That opens the door for the Federal Reserve (Fed) to lower short-term interest rates. In addition, long-term interest rates could move lower.
The CPI showed that overall inflation year-over-year (YOY) was 2.4% and core CPI, excluding food & energy (CPI ex F&E) was 2.5%, the lowest rate since April 2021 and down from a rate of 6.6% in October 2022. That is clear evidence that consumer inflation is moving toward the Fed’s long-term inflation goal.
The CPI ex F&E report is a long-standing report that is similar to but not the preferred inflation measurement of the Fed. The Fed’s preference is the Personal Consumption Expenditure (PCE) ex F&E report because it accounts for changes in consumer buying behavior. The CPI report is a fixed basket of commodities. The next PCE report is scheduled to be released next Friday. That report has recently shown a similar pattern but has been a bit higher and more level than the CPI ex F&E.
The market reaction was a drop of 6 bps in the 2-year Treasury rate and a drop of 7 bps in the 10-year Treasury rate. That means that the market believes that it is more likely that the Fed will lower short-term interest rates and that it will not spur longer-term inflation. Per the CME group, the market currently expects two Fed rate cuts of 25 bps this year.
If the inflation reports continue in a downward path, it is likely that the Fed will be more aggressive than the market expects. The Fed has 12 members including the chairman. Two of the current members have been appointed by the current president. A new chairman has been nominated to fill the role beginning in May. All those members appointed by the president are expected to favor lower short-term rates. More importantly, the current Fed funds rate is very high relative to inflation measured by the CPI ex F&E.
Since 2000 the Fed funds rate has been, on average, 40 bps below the CPI ex F&E. Currently, it is more than 100 bps above the CPI ex F&E and has been since September 2003. The only other time since 2000 that the Fed funds rate has been that high relative to the CPI ex F&E is the period from June 2005 to January 2008. That preceded the market meltdown in 2008 mostly related to home mortgages.
The environment is different today, but the risks can be as significant. The high-rate period of 2005-2008 followed an aggressive rate reduction period from November 2000 to December 2001. The current high-rate period follows a similarly aggressive rate reduction period from October 2019 through May 2022 from an already low level. The difference is that in the prior period long-term rates stayed higher relative to the short-term rate, creating what’s call a steep yield curve. Such a difference in rates for an extended period encouraged adjustable-rate home mortgages indexed to Libor or other short-term indexes and home lending practices were weakened. That situation does not exist today but borrowers, such as businesses taking leveraged loans are just as vulnerable. It is currently reported that over $550 billion of such high-priced, typically SOFR-indexed loans made by unregulated lenders exist. It is possible that AI-induced business turmoil could lead to disruption in that market.
Fed members are likely to see and measure such risks. If the risks become more prevalent, it is more likely that the Fed will lower short-term rates more aggressively. If that happens and inflation remains in check, then long-term rates will also drop.