Inflation Monitor: Cost Pressures to Mount, Demand Pressures to Weaken

Summary

• March CPI was 20bp MoM lower than expected with large declines in used cars and core services ex housing pulling down the index.
• Trend inflation remains stable to upwards.
• Short-term Inflation expectations continue rising but long-term market-based expectations, which matter most to the Fed, remain stable.
• Cost pressures are about to increase with the implementation of tariffs, though lower energy prices could partly offset this.
• With a recession on the horizon, demand pressure will eventually abate, which will limit the second-round impact of the tariff hikes on inflation.

Market Implications

• Because a recession is now my base case scenario, I expect the Fed to cut about 150bp, mostly in 2025.

Large Negative March CPI Surprise

Headline and core CPI came in 0.2% below consensus (Table 1 and Chart 1). Sam’s model had predicted a downside surprise.

The slowdown mainly reflected a decline in goods and services ex housing inflation (Table 2):

• Core goods inflation slowed across the board (Chart 2).
• OER rose again (Chart 3).
• Supercore services inflation slowed, largely due to transportation services contracting by 1.4% MoM, following a 0.8% decline in February (Chart 4). Transportation services demand and prices tend to be procyclical and the two consecutive months of decline could signal demand weakening.

Stable to Upward Trends

Inflation trends remain stable.

• March Core CPI was consistent with inflation stabilization above the target with declining shelter inflation offsetting rising goods inflation (Chart 5). However, with the tariffs goods inflation is about to jump while shelter inflation could be stabilizing.
• CPI indices that exclude the more volatile price components continued sliding (Chart 6).
• Besides core CPI, the components that best predict future headline CPI are food, shelter and health care, according to the St Louis Fed. Food inflation remains on an uptrend, while the trend for medical inflation is less clear (Charts 7, 8, and 3).

Short-term Inflation Expectations Still Rising

Most measures of inflation expectations have been rising over the past month. The exception is the 5y5y BE, which is the Fed’s preferred measure of long-term inflation expectations.

• Following the tariff announcements, two-year BEs have risen further (Chart 9). 5y5y BEs are roughly unchanged.
• Short-term and long-term University of Michigan consumer survey inflation expectations have kept rising (Chart 10).
• Consensus forecasts for 2025 inflation have kept rising (Chart 11).
• FOMC concerns over inflation risks were higher at the March than at the December FOMC, even though the Fed’s own index of inflation expectations remains stable (Chart 12).

Tariffs to Add to Cost Pressures

Tariff increases will boost already emerging cost pressures. Tariffs are not included in the import price index but are likely to lift PPI and CPI as importers, wholesalers, and retailers pass on cost increases to customers.

• Tariffs could be absorbed through exporters lowering their prices. By contrast, we expect the dollar weakening will add to cost increases (Chart 13).
• Even before the tariff hikes, import prices, which have been leading the core goods CPI, have been rising (Chart 14).
• Global oil prices have recently fallen, which could partly offset the tariff increases (Chart 15).
• Unit labour costs (= wage costs per unit of output) have started accelerate on slower productivity growth (Chart 16). Productivity is set to slow further as the business environment has become unstable and unpredictable, which will likely hit capex.

Recession to Weaken Demand Pressures

The US is likely to enter a recession in Q2 due to unprecedented uncertainty and the loss of real income caused by tariffs. This will limit the second-round effects of tariffs on inflation.

• San Francisco Fed decomposition of core PCE between demand and supply factors shows demand-driven core PCE accelerating (Chart 1). By contrast, supply (i.e., cost-driven inflation) is slowing. These trends are about to reverse.
• Consumer and small businesses confidence is falling (Chart 18). The short-term impact on spending could be hidden by increased goods purchases in expectation of more tariff hikes. But this raised spending will eventually reverse.
• Labour market is likely to loosen further (Chart 19).
• Prospects for fiscal consolidation remain uncertain with risks the Trump administration could indemnify those hit by its tariff policies (Chart 20)

Market Consequences

Inflation dynamics are about to reverse. Cost pressures are about to rise and demand pressures weaken, with an uncertain short-term impact on overall inflation.

The Fed is looking beyond short-term inflation developments. Rather, it is focused on medium-term risks of second-round tariff effects. In turn, those are likely to be driven by the depth of the forthcoming recession. In a deep recession scenario, second round effects will be limited and the Fed could look through the tariffs and focus on unemployment. In such a scenario, the Fed could cut as much as 300bp.

By contrast, should the administration tariff policies turn out gradual and predictable, their impact on the economy could be limited to self-correcting demand weaknesses. In this instance, second-round effects could be substantial, and the Fed may not cut at all.

The administration is most likely to land the US economy between these polar cases, which suggests inflation peaking around 4.5% and unemployment around 6.5%. In this instance, the Fed could cut about 150bp, mostly in 2025.

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