Inflation Monitor: Higher Costs and Weaker Demand?

Summary

• February CPI surprised on the downside but did not change my big picture view of inflation, stuck about 1ppt above the Fed’s 2% target.
• However, risk exists the Trump administration’s policies could raise costs and weaken demand, with uncertain inflation impact but a negative growth impact.

Market Implications

• I keep my call for no Fed cuts in 2025 against markets pricing about 3.5 cuts because I expect the administration to change its policies before their negative impact on growth becomes irreversible.
• I will change my Fed view if this does not happen within a few weeks.

Negative February CPI Surprise

Headline and core CPI were below consensus (Table 1, Chart 1). The surprise was small. MoM core CPI at 23bp was only 3bp below a number that would have rounded up to the consensus of 0.3%. Sam’s model’s predicted a small upside surprise.

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

• Core goods inflation slowed due to goods other than used cars (Chart 2).
• OER was roughly unchanged and seems to be stabilizing around 30bp MoM (Chart 3).
• Supercore services inflation slowed, largely due to transportation services contracting by 0.8% MoM, down from a 1.8% increase in January (Chart 4).

Rising Inflation Expectations

Market-based and survey-based inflation expectations have generally been rising or remain high.

• Following yesterday’s CPI release, the Cleveland Fed nowcast for February core PCE fell to 19bp MoM and that of March to 21bp (Chart 5).
• Over the past month, two-year BEs have remained stable above 3%, compared with 2.3% before the US presidential election (Chart 6). 5y5y BEs are roughly unchanged.
• Over the past month, consensus inflation forecasts for 2025, 12m/12m, continued increasing (Chart 7).
• One year ahead University of Michigan inflation expectations have been rising since November, long-term inflation expectations since Q1 2024 (Chart 8).
• By contrast, the Fed’s Index of Common Inflation Expectations and the Cleveland Fed Firms’ Inflation Expectations were stable (Chart 9).
• Even FOMC concerns over inflation risks have been rising (Chart 10).

Tariffs to Increase Cost Pressures

The introduction of tariffs is likely to 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 the cost increases to customers. I think this will have a one-round impact (i.e., a price level impact rather than triggering an increase in inflation depends on businesses’ market power, i.e., economic slack (or the lack of it).

• Import prices, which have been leading the CPI, have been rising (Chart 11).
• Unit labour costs (= wage costs per unit of output) have started rising due to slower productivity growth (Chart 12).
• Fed speakers have recently noted market-based PCE has been increasing more slowly than inputed price PCE and I expect the latter to slow down to the former (Charts 13 and 14). While the gap between market and non-market core PCE is about average, it could close through an acceleration in market-based PCE if demand and cost pressures intensify.

Demand Pressures Could Abate

Currently, evidence exists of demand pressures. However, the administration’s policies have seen a surge in uncertainty that is starting to weaken demand. Continued high policy uncertainty is likely to see demand pressures abate.

• The San Fransico Fed decomposition of core PCE between demand and supply factors shows demand-driven core PCE is accelerating (Chart 15). By contrast, supply (i.e., cost-driven inflation) is slowing.
• The worsening of the current account balance indicates excess domestic investment over domestic savings (i.e., demand pressures, Chart 16).
• For now, the labour market remains tight and could get tighter if the administration aggressively implements its deportation program (Chart 17).

The prospects for fiscal consolidation remain uncertain, which suggest limited downside risks to demand from fiscal policy (Chart 18).

Inflation Trends Stable or Rising

On balance, measures of inflation trends point more at stabilization or at upside risks than at downside risks.

• February Core CPI was consistent with inflation stabilization above the 2% target (Chart 19). Goods price deflation is too small to offset still high services inflation. Also, tariffs are coming, goods price deflation is ending and risks exist that OER could be stabilizing.
• CPI indices that exclude the more volatile price components are mixed. Sticky price and median price inflation is still falling but trimmed mean has stabilized (Chart 20).
• Besides core CPI, according to the St Louis Fed, the components that best predict future headline CPI are food, shelter and health care. Food inflation remains on an uptrend, while the trend for medical inflation is less clear (Charts 21, 22 and 3).

Market Consequences

In my last Inflation Monitor, I listed several demand and cost pressures. However, since then the administration’s policies have increased upside risks to costs and downside risks to demand, with a mixed impact on inflation.

The administration’s tariff hikes are likely to raise costs. Deregulation could lower costs to businesses, but it seems more likely to come after the tariff hikes. So far, the administration has been much more focused on the latter than the former.

In addition, the administration has generated so much uncertainty that household and business spending has started weakening. The administration is implementing tariffs in an abrupt and unpredictable manner that maximises their negative impact on the US economy. So far, the damage is not irreversible. confidence can be restored, and consumption, employment and investment plans can still return to their pre-inauguration trajectory.

Chair Powell was likely referring to these factors in his 7 March speech when stating, ‘the net effect of the administration policy changes that will matter for the economy and for the path of monetary policy.’

I assume rationality will prevail and that the administration will soon course correct, implement its policies in a more predictable manner and restore confidence and keep growth on the current, high trajectory. On that basis, I maintain my call for no Fed cuts in 2025.

However, if the administration persists with its destabilizing statements, I will lower my growth forecast and change my Fed call.

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