Inflation is Heading Higher Again. Is It a Bump in the Road or Something More?

A surge in inflation earlier this year coupled with robust economic expansion is expected to maintain high U.S. interest rates, albeit likely for a brief duration.

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Federal Reserve Chair Jerome Powell stated on Friday that the February report on inflation and consumer spending yielded no significant surprises. This suggests that the Fed remains committed to its plan of reducing interest rates three times this year, a sentiment echoed by most economists.

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However, there is some disparity among economists and senior Fed officials, like Gov. Chris Waller, regarding the timing of these rate cuts. Some argue that inflation must decelerate further, and the economy needs to cool down slightly before the central bank takes action. Presently, Wall Street anticipates a rate cut in June, although July or later is not ruled out.

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Chief economist Scott Anderson of BMO Capital Markets emphasized the necessity for more evidence of inflation moderation in the coming months to instill confidence in the Fed to proceed with its rate-cutting agenda.

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The primary concern revolves around persistent inflation. Prices surged notably in January and February, reversing a steady decline observed towards the end of the previous year. The Fed's preferred inflation measure, the personal consumption expenditures (PCE) price index, rose by 0.3% in February following a 0.4% increase in January. If this trend continues, it could push the annual inflation rate back above 3%.

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Despite these concerns, Powell appears unfazed. He anticipates inflation to continue its slowdown trajectory, albeit acknowledging potential hurdles on the path towards the Fed's 2% annual inflation target.

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Although the 12-month rate of PCE inflation is not far from the 2% goal, standing at 2.5% in February, it has shifted course since December and has exceeded 3% in the past three months on an annualized basis.

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However, the February PCE inflation report did offer some positive aspects. The cost of services, which has been a significant contributor to recent inflation, moderated after a substantial increase in January. Additionally, the "supercore" rate of service inflation, excluding energy and housing costs and serving as a labor cost proxy, experienced a slight uptick.

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The main question looming is whether this moderation can be sustained, especially given the robustness of the U.S. economy. Consumer spending surged by 0.8% in February, marking the largest increase in a year. Gross domestic product (GDP), the official measure of economic performance, is expected to rise by approximately 2% in the first quarter, showcasing the economy's resilience.

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Despite potential challenges, including sustained wage growth, a solid job market, and low layoffs, the economy remains robust. Even if inflation doesn't decelerate as rapidly as anticipated, the strength of the economy provides a buffer. Powell emphasized that the possibility of a recession is not heightened currently, with growth remaining strong and the economy in favorable conditions.

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Top economists on Wall Street forecast steady U.S. growth in 2024. While they anticipate a slower decline in inflation than desired by the Fed, they still anticipate three interest rate cuts this year. They argue that current interest rates are sufficiently high to allow the Fed to implement cuts without reigniting inflation.

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However, the accuracy of these predictions remains to be seen, with the next consumer price index release scheduled for April 10th.

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