Is the pressure off? Inflation likely to die down in February, but don’t get used to it

March 26, 2018

U.S. trade fights could add to inflation later on if they get worse

Inflation is rising in the U.S., but it’s stilling falling short of the Federal Reserve’s 2% annual target.

A fistful of trade fights under President Trump is worrying the heck out of Wall Street, but investors are still anxious about the threat of inflation. If it keeps rising, so will U.S. interest rates.

The latest look at inflation comes Thursday via the Federal Reserve’s preferred gauge known as the PCE index. The yearly rate of inflation started to rise from nearly zero in 2015, reaching 1.7% in January. And that’s fraying some nerves.

Jerome Powell, in his first press conference a new Fed chairman, offered soothing words last week. “There is no sense in the data that we are on the cusp of an acceleration in inflation,” he said.

Personal consumption expenditures price index
Percentage change from previous year, seasonally adjusted

Just to be safe, though, the Fed took out a little insurance against the economy overheating by raising its benchmark interest rate for the sixth time since 2015. That put the so-called fed funds rate at 1.5% to 1.75% — the highest level in almost 10 years.

Rates TMUBMUSD10Y, +0.42% are still extremely low by historical standards, but they can still pinch. Higher rates make stocks SPX, -2.10% less attractive than bonds, for instance, and it means home or car buyers have to pay more for loans.

How much higher rates go — and how fast — will depend on inflation. In all likelihood, inflation pressures subsided in February after a runup in January largely caused by higher oil prices. The cost of petroleum fell last month.

The 12-month rate of inflation measured by the PCE could even dip to as low as 1.5%, analysts say, well below the Fed’s 2% target.

Indeed, the central bank is sticking to its forecast for three rate hikes this year in part because it doesn’t think inflation will shoot past 2%.

“Underlying inflation remains stubbornly below the Fed’s 2% target,” noted senior economist Jennifer Lee of BMO Capital Markets. “This more than anything explains the Fed’s go-slow approach.”

But now there’s the new wrinkle: Trade fights.

The White House has already applied tariffs to many foreign producers of steel, and last week it announced plans to put tariffs on $50 billion in Chinese goods, spurring another big selloff in the U.S. stock market DJIA, -1.77%

These moves could raise the cost not only of U.S. imports, but of US-produced goods such as steel that are protected from foreign competitors. U.S. steel prices, for instance, surged after the tariffs were announced.

The effects on inflation appear modest at the moment, but if the trade disputes intensify it could “increase inflationary pressures on U.S. consumers and eventually force the Fed onto a faster rate hike path,” said chief economist Scott Brown of Bank of the West.

That’s probably a worst-case scenario and it’s far too early to get worried. But it’s certainly bears watching.