The Fed is challenged by higher inflation in Q1

The latest figures confirm the pick-up in US inflation over the past few months, with the Fed signalling that interest rates are likely to stay high for longer amid more policy-makers questioning whether the neutral policy rate has risen from pre-COVID levels.   

Ahead of the Fed meeting on interest rates on 30 April-1 May, markets and policy-makers have been on something of a rollercoaster, with Thursday's national accounts showing greater price pressures than had been expected in Q1, in that the Fed’s preferred core PCE deflator increased by an annualised 3.7% in the quarter ahead of the release of the March inflation numbers the next day.

The strong quarterly result briefly raised the possibility of an alarmingly high print for inflation in March, but in the end the numbers were reconciled by a slight upward revision to January – albeit still rounding to an increase of 0.5% – and with another 0.3% increase in March, which was a little above the initial consensus forecast of 0.25% and in line with the Fed’s recent estimate.

Running a simple filter through the numbers to estimate the trend, annualised monthly core PCE inflation has picked up from about 2% late last year to 4%. 

Stripping out most imputed prices, the “market prices” measure of annualised core PCE inflation has also picked up, but not by as much, increasing from about 2% late last year to 3½%.

Focusing on the Dallas Fed’s trimmed mean PCE deflator, which captures the breadth of prices increases, the news was actually a little better in that it only rose by 0.2% in March, although this was not enough to stop the annualised trend accelerating from 2½% late last year to around 3½%.

(There are also model estimates of core inflation, most notably the NY Fed’s “multivariate core trend inflation” series that is favoured by Fed Vice Chair Williams, but these are published with a slight delay, with the NY series showing around annual inflation rising from 2½% in late 2023 to 3% in February.)

The downside to these trend estimates is that they can be revised as more data become available, but if the different measures of core prices continue to grow at a similar rate over the next few months then the trend in inflation would range between 3 and 3½%.

On that basis, inflation would still be tracking above the Fed’s forecast trajectory, which has annual core PCE inflation slowing to about 2½% by the end of this year.

This inflation surprise, together with the labour market proving more resilient than had been anticipated, has seen the Fed change its signalling on policy, now factoring in holding rates high for longer amid more policy-makers questioning whether the neutral policy rate has increased from pre-pandemic levels.

The challenge for the Fed is that much of the improvement in inflation to date has reflected weaker goods prices, where the impact of unprecedented COVID supply disruptions has largely been unwound, whereas services inflation has proved more persistent against the background of a still-tight labour market.

Central banks have often framed this challenge as the difficult “last mile” of returning inflation to target, which is a roundabout way of acknowledging that their analysis shows that in normal times inflation is not overly responsive to high interest rates.

As for consumer spending – which accounts for close to 70% of the US economy – it remains strong, increasing by another 0.5% in March, with the unexpected 0.3% decline in January increasingly looking like an aberration.

The estimated trend in annualised monthly spending has picked up to 4%, up from about 2% earlier last year.

On CCI's calculation, US consumers look to have exhausted the excess savings built up during COVID, but spending is being buoyed by strong growth in both incomes and wealth.