Despite overall inflation decelerating over the month, both core inflation and super core inflation—core services excluding shelter—accelerated in February. Today’s CPI report indicates that the inflation rate may take longer to reach the 2% target than markets were anticipating.
Coming on the heels of last Friday’s strong jobs report and Fed Chair Powell’s semiannual report to Congress, today’s acceleration in core inflation would almost certainly push the Fed to raise rates by 50 bps on March 22 were it not for recent instability in the banking system. Now, the Fed is in a bind. On the one hand, it wants to maintain credibility on inflation and avoid core inflation accelerating further. On the other, it needs time to investigate the effect of recent bank collapses on financial conditions and wants to minimize the risk of further financial instability.
A 50bp hike would bring interest rates to the 5.25% target terminal rate communicated by the Fed a year ago. If core inflation remains stubborn, however, the Fed may continue raising rates beyond 5.25% in the second half of the year, and keep rates high for longer. As it does so, risks to financial instability and the labor market will only compound.
Although core inflation has not shown the smooth downward trend desired by the Fed, when considering all economic data—including decelerating wage growth, a broader slowdown in hiring across a wider range of industries, and the recent decrease in inflation expectations—rate hikes do appear to be having their intended impact on the economy, and the disinflationary process has already begun.
Uncertainty around how high and sticky interest rates will be, combined with the rising instability in financial markets, is making employers more conservative with their hiring decisions. Many businesses across multiple industries would like to wait and see before they commit to expanding their payrolls, lest they have to downsize 6 months from now in a downturn. As a result, business uncertainty is likely to slow the job market further and ease the Fed’s job of keeping prices under control.
Here are the highlights of today’s report:
- The index for shelter was by far the largest contributor to the monthly all items increase, accounting for 70% of the monthly all items increase, with the indexes for food, recreation, and household furnishings and operations also contributing. Private data from Zillow showed that the slowdown in home sales and rental prices has recently reversed. That could mean high shelter prices might stick around a little longer than desired as the housing market enters the spring home buying season.
- Super core inflation: Inflation in super core services has accelerated over the month, likely driven by the strength in consumer spending on services. The super core inflation is the reading that the Fed closely watches when it comes to setting the size of the rate hikes. So we are likely to end the first quarter of the year with a 50 bp rate hike, rather than a smaller than the experts were expecting a month ago.
- Real earnings: There is promising news on the labor market side. Real earnings decreased 0.1% in February as a result of an 0.2% increase in average hourly earnings combined with 0.4% in the CPI. Negative real wage growth might slow down demand for goods and services and could potentially help the Fed cool the economy in the coming months.