Economic headwinds
On February 12th, inflation hit 3% for the first time in seven months. The continued stalled progress on taming price growth will keep central bank officials from lowering interest rates and could even raise the specter of rate hikes. The latest reading widens the gap to the Fed’s 2% inflation target. The report is based on January and Biden’s last minute out of control spending. It will take some time for the Trump administration to get the situation under control and start taking measures to bring the inflation down to 2%. The next Fed meeting is not until March 18-19, which means the February inflation data will be available prior to that meeting.
Overall, consumer sentiment surprised to the downside in February’s preliminary reading. Among 46 economists polled by Bloomberg, none expected it would be this sharp a decline. Sentiment is now at its lowest point since July 2024. The current conditions index dropped 5.3 points to 68.7, indicating consumers feel uncertain about the current state of the economy. Consumer expectations were down as well, falling 2 points to 67.3, its lowest point since December 2023.
Nowhere was this shaky feeling more evident than in the full percentage point spike in short term inflation expectations. This makes for two consecutive months of uncharacteristically high jumps in short-term inflation expectations. Long term inflation expectations rose a touch to 3.3% from 3.2% in January. Though not nearly as dramatic of a one-month increase, this still represents an elevated rate relative to the range that prevailed pre-pandemic.
So what has changed over the past two months to drive such an increase? The survey period ran from January 21st through February 3rd, with the end of this period coinciding with the day that tariff policy took center stage amid the current administration’s implementation of 25% tariffs on Canadian and Mexican goods imports, as well as a tariff of 10% on Chinese goods. Given the 30-day stay-of-execution granted on Monday for Mexico and Canada, perhaps this preliminary read will get revised down as more surveys come back later in the month.
There has also been a significant widening in the trade deficit, and combined with how tariff policy remains in focus and how it’s not just actual policy but the prospect of changes in those policies that can dictate economic behavior. Overall voters feel more confident about the economy with Trump back in the White House, but there is a lag in the economy, and Biden’s actions will still linger for a while. Also, Trump is creating stress with continued threats of new tariffs and will most likely soon turn to Europe and the EU. That might trigger a trade war. Long-term, the fight is worth it, argues Trump, as Americans are treated unfairly. Short-term though, there will be tension and market volatility.
Policymakers at the Federal Reserve have cited consumer expectations of inflation as a factor they consider as a leading indicator for their price stability mandate. Today’s surge in year-ahead inflation comes along with other price signals this week that are not favorable for the Federal Reserve to deliver on expected rate cuts. The prices paid component of the ISM manufacturing survey rose to 54.9, an eight-month-high. Meanwhile, despite a slowing in service sector activity reported in the services ISM, the prices paid component came in above 60 for the second month in a row, a sign that pricing pressure remains widespread among service providers as well.
The inflation data is however a headwind and a headache for the Fed and for the Trump administration. Prices rose 0.5% at the start of the year, compared to consensus expectations of a 0.3% gain. On a year-over-year basis, prices rose 3.0%, the strongest 12-month change since June. Part of the headline’s strength can be tied to a surprisingly large lift in energy prices. Energy goods prices rose 1.9% amid strength in gasoline prices and fuel oil, overshadowing a more temperate rise in energy services. Meantime, the upswing in food inflation continued in January. Grocery prices rose 0.5% amid another leap in egg prices (+15.2%) and are up 1.9% over the past year. Prices for food away from home rose a more modest 0.2% but continue to see more firm growth on trend having advanced 3.4% over the past year.
On the services side, core prices rose 0.5%. The closely-watched shelter component rose 0.4% over the month, with both rent of primary residences and owners’ equivalent rents rising 0.3%, in line with their six-month averages. Lodging away from home, however, helped lift the shelter component with a +1.4% rise over the month, which we see as partially tied to the L.A. wildfires given higher-than-usual occupancy in the area during the month. Beyond shelter, outsized gains in motor vehicle insurance (+2.0%), airline fares (+1.2) and recreation services helped drive core services higher.
The Fed might have to be more careful than previously expected and it will be difficult to kick-start the economy in 2025 without having the inflation under control. This might create some issues for the economy and for the new administration, even though it will most likely not impact Trump’s policy decisions related to tariffs.
Fed officials have made clear that they are in no hurry to adjust the current stance of monetary policy. With inflation still running above the target, the labor market looking sturdier after last summer’s wobble and heightened uncertainty around economic policy changes, the Fed might have settled into a prolonged hold. It is too early to speculate about the fall, the previously the expectation was for two 25 bps rate cuts in September and December of this year, but now the risks are skewed toward no cuts this year if the inflation data do not cool quickly further in the months ahead.