Strong US core inflation before the energy shock hits

Ahead of a likely small spillover from the spike in energy prices, US core inflation remained high in February, although the strength was still narrowly based. Tariffs continue to flow through to retail prices and services inflation was solid.

Central bank modelling shows higher energy prices have a small impact on core inflation, as long as inflation expectations remain anchored by the inflation target, where there should be some spillover from higher transport costs and the like. In this respect, it is encouraging that early readings on medium- to long-term measures of inflation expectations have been broadly stable.

The Fed next meets on 28-29 April ahead of the expected handover from Fed Chair Powell to former Fed governor Warsh in mid May (note that the handover could be delayed as key Republican Senator Tillis is blocking the appointment of Fed nominees until the Department of Justice criminal investigation into the Fed and Fed Chair Powell is resolved).

The Fed should keep rates on hold again amid a shift among committee members towards adopting a neutral policy stance. Simple policy rules continue to suggest that the funds rate should have been held around 4% because inflation is still above target and a range of indicators suggest that the neutral funds rate has increased over recent years.

In terms of how the Fed could react to the unprecedented disruption to the world supply of energy and key commodities, scenarios suggest that:

1. There are no implications for the Fed if the disruption proves short-lived, other than to talk tough to make sure inflation expectations remain anchored by the inflation target;
   
2. If supply remains disrupted for an extended period, the Fed might consider cutting rates depending on what happens to unemployment, although any easing would likely be modest because it would be constrained by higher inflation;
   
3. If supply remains disrupted for an extended period and the Fed becomes worried about inflation expectations, then modest rate hikes would be likely; and
   
4. Regardless of the duration of supply shortages, rising inflation expectations – something not seen since the 1970s – would be met by aggressively higher interest rates.

As for the detail of last night’s data:

• Strong core inflation was slightly above the FOMC’s forecast profile …
  The core PCE deflator, which is constructed differently to the core CPI and has a broader coverage of prices, rose strongly again in February, up another 0.4% in the month. Annual inflation edged down to 3.0%. Estimated trend annualised monthly inflation is running at about 4.5%, where this calculation will be revised as more data become available. The 3-month annual inflation rate was steady at 3.0% in February, marginally above the implied median FOMC forecast of 2.8% for Q1.
  
• … but strong inflation was narrowly based.
  The strength in inflation continues to be driven by a small number of prices, as the trimmed mean PCE deflator is increasing more slowly, rising at an annual rate of 2.3%.
• Tariffs continue to boost goods prices, where the effect should fade from mid year.
  Tariffs continue to be reflected in higher prices for goods. Core goods prices rose by 0.8% in February after a 0.3% increase in January. Prices are up 2.3% over the past year. The impact of tariffs should fade from around the middle of this year onwards.
• Services inflation is still solid.
  Core services prices are growing solidly, although monthly gains have been volatile. Prices rose by 0.2% in February after a 0.4% gain in January. Annual inflation edged down to 3.2% (3.3% excluding housing), while estimated trend annualised monthly inflation has picked up to 3¾% (4¼% excluding housing).
• Measures of global supply shortages have picked up.
  The news-based measure of shortages has picked up more than the better-constructed NY Fed measure of global shortages. Shortages are likely to intensify, particularly in Asia, which is the world’s manufacturing hub.
• Volatile US consumer spending has been weak ahead of a likely decline in later March/April.
  Monthly consumer spending is exceptionally volatile and the numbers can be revised. In real terms, spending rose by 0.1% in February after a flat January and is up 2.5% over the past year. Spending has been running ahead of income and will likely contract in late March and April due to the spike in higher energy prices.