Kevin Lings: US consumer inflation eased – Big decision ahead for the Fed

By Kevin Lings – Chief Economist at StanLib

In February 2023 US consumer inflation rose by 0.4%m/m, helped by a further decline in used vehicle prices, a drop in piped gas prices and a decline in the cost of medical care services. In contrast, shelter inflation rose by a further 0.8%m/m. The February increase was in-line with market expectations, pulling the annual rate of inflation down to 6.0% from 6.4% in January 2023. US inflation is now well below the recent peak of 9.1%y/y that was recorded in July 2022, and is expected to slow appreciably further in the months-ahead (see chart attached).

Crucially, core consumer inflation also moderated in February, but slightly less than market expectations. In particular, core inflation rose by 0.5%m/m in February, compared with market expectations for an increase of 0.4%. Nevertheless, the annual rate of core inflation slowed to 5.5%, although this is only slightly below the 5.6%y/y recorded in January 2022. In addition, super-core inflation (core services inflation less shelter) eased from around 6.2% in January 2022 to just over to 6.0% in February. While the key measures of core inflation continue to slow, the underlying rate of US inflation remains uncomfortable higher and well above target, suggesting that the Fed needs to do more to bring inflation under-control, and argues for a further 25bps increase in US interest rates next week.

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In that regard the recent failure of Silicon Valley Bank (SVB) (and concerns about the viability of other smaller banks, and hence the rise of financial market instability) has created a dilemma for the Federal Reserve. It seems reasonable to argue that if the Fed feels that the measures recently introduced to safeguard bank deposits has done enough to calm the situation then they are likely to continue to hike rates, flagging the fact that a range of economic data remains relatively robust (including the labour market) and that inflation has not moderated sufficiently. Alternatively, the Fed could argue that they need to pause rates hikes to better ensure financial market stability and more fully assess the impact of higher interest rates on the broader economy. This would be equivalent to the Fed admitting that the speed of interest rate hikes has created unintended consequences that have to be fully managed before the fight against inflation can resume. This would, obviously, be more difficult to communicate effectively, and make it challenging for the Fed to resume rates hikes at a later stage should inflation not slow appreciably further. 

Lastly, the continued increase in shelter inflation (+0.8%m/m in February 2023, rising 8.1%y/y) is playing a major role in keeping the overall rate of US inflation elevated. Fortunately, a range of private sector data continue to suggest that shelter inflation should begin to slow meaningfully over the coming months. This will go a long way in easing concerns about inflation is not moving closer to the target of 2% by the end of 2023. However, the pending fall-off in shelter inflation is unlikely to be sufficient to ensure that core inflation is back down at 2% in early 2024 – hence the argument that US economic activity need to slow further (including the labour market) to ensure a benign inflation outlook over the medium term.

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Overall, the trend in both headline as well as core consumer inflation remains encouraging, suggesting that the increases in US interest rates is slowing having the desired impact. Nevertheless, it is going to be difficult for the Fed to achieve its inflation target within a reasonable timeframe without hiking US interest rates further and without pushing the US economy into recession. Stated differently, having a very high level of inflation that broadened into a wide range of categories (including shelter) at the start of the interest rate tightening cycle made it much less likely that the Fed could avoid pushing the US economy into a substantial downturn as it tries to control inflation – especially considering the speed at which rates were increased. While, the rate hikes have triggered some financial market instability, it would be awkward/embarrassing for the Fed to admit that a lack of rigorous financial market oversight prohibits the FOMC from achieving their stated inflation objective.

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