Market Brief: Inflation Heats Up, Clobbering Fed Bets

Consumer price growth accelerated in the United States last month, bolstering the case for a cautious approach to easing from the Federal Reserve—and raising the odds on a rate hike at some point this year. According to the Bureau of Labor Statistics, the headline all-items consumer price index climbed 3.0 percent year-over-year in January, accelerating slightly from the 2.9 percent pace set in December, and rose 0.5 percent from the previous month. The core measure—with highly-volatile food and energy prices excluded—rose 3.3 percent in January from the same period last year, and rose 0.4 percent on a month-over-month basis, marking its fastest advance since March last year. And the unexpected acceleration in nominal wage growth exhibited in Friday’s non-farm payrolls report kicked the so-called “supercore” measure higher, with core services excluding shelter costs climbing 0.76 percent relative to the prior month, up 4.02 percent over the prior year.

Markets are not taking the news well. The dollar is advancing, major equity indices are set to drop at the open, benchmark ten-year Treasury yields are climbing and the yield curve is flattening. Currencies outside the US are retreating en masse against the greenback.

In theory, hotter inflation could end the Federal Reserve’s rate-cutting campaign, but—as highlighted yesterday—new seasonal adjustment factors and “January effect” in corporate pricing strategies could be playing havoc with the data. It will take time to determine whether we’re seeing a resurgence in inflation pressures, and even longer to determine the longer-term direction for price growth. For now, it seems likely that the central bank will have to reassess the restrictiveness of current policy, and is likely to conclude that further easing would be unwise.

In yesterday’s Congressional testimony, Chair Jerome Powell expressed confidence in the economy’s underpinnings, telegraphed a more gradual pace of easing ahead, and said that the central bank would take a wait-and-see approach to assessing the impact of President Trump’s policies. “We’re in a pretty good place with this economy,” he said, so “We do not need to be in a hurry to adjust our policy stance. We know that reducing policy restraint too fast or too much could hinder progress on inflation”. In comments on the rapidly-evolving political backdrop, he cautioned “It really does remain to be seen what tariff policies would be implemented. It would be unwise to speculate when we really don’t know. We see proposals, but it’s so hard to say what will happen… It’s really not just tariffs. It’s tariffs, immigration, fiscal policy and regulatory policy. We’ll try to make sense of it and do what’s right for monetary policy”. Powell is expected to repeat this message when he delivers a second round of testimony before the House Financial Services Committee this morning.

From a broader perspective, it is clear that the dollar has lost upward momentum. Although we did take a relatively-bearish view on the currency’s longer-term prospects back in December, we had expected the greenback to remain relatively firm through the first quarter, with investors remaining enthusiastic about the American economy’s prospects even as traders maintained hedges against trade-related shocks in other countries. That does not seem to be playing out in reality: on a trade-weighted basis, the dollar is now down on a year-to-date basis, suggesting that market participants are taking a more downbeat view on the US growth outlook and turning more skeptical on the likelihood of tariffs making it off Donald Trump’s desk and into reality. Bets against the Canadian dollar, Mexican peso, Chinese yuan, and euro simply haven’t paid off.

We don’t think the skies have suddenly cleared. A period of consolidation was always probable after big gains in the ‘Trump trade’ at the end of last year—and overheated campaign rhetoric was never likely to translate into policy action on the scale that had been feared—but the president’s enthusiasm for imposing protectionist measures on Canada, Mexico, and the euro area seems undimmed. Downside risks in all three currencies remain significant, and market participants will remain hesitant to trade into rallies for now. The dollar has a few more spikes to deploy.

Measures of economic sentiment expressed in the media have turned sharply downward after an initial surge in positive coverage of the Trump administration’s plans, indicating that the “vibecession” dynamic that remained in place throughout Biden’s term could be making a comeback.

Some have suggested that this could reflect worries about a fiscal consolidation that could slow the broader economy. This

doesn’t seem likely: the vast scale of government outlays on politically-untouchable defence and entitlement programmes—along with interest payments—is likely to defy the best efforts of Elon Musk and his merry band of cost-cutters (foreign aid and employee payrolls make up a tiny share of spending), leaving the fiscal impulse in narrowly-positive territory. Instead, normal cooling in the business cycle, a moderation in hopes around the artificial intelligence boom, and the Trump administration’s sheer unpredictability could be weighing on sentiment among businesses and households.

*In several appearances in recent years, Jerome Powell suggested that inflation in core services other than housing was perhaps "the most important category for understanding the future evolution of core inflation," but he was referring to a measure derived from the personal consumption expenditures release, not the consumer price index. The two are not synonymous.

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