Quantum of solace: Inflation cools ahead of tariff-induced price increases

Inflation cooled in February, but consumers aren’t buying it. Instead, for a host of reasons, consumers expect inflation to continue rising in the coming year from its 2.8% yearly rate. The same holds true for the financial markets that have been pricing above target inflation for the past three years.

The latest survey by the University of Michigan, released March 14, suggests that households expect inflation to increase to 4.9% over the next 12 months, noting that long-run expectations have risen in recent months and are elevated relative to the two years prior to the pandemic.

Although consumer expectations remain below peak readings during the postpandemic inflationary episode, the University of Michigan analysis finds substantial uncertainty among households, particularly in light of the trade policy of the new administration.

To that point, consumers seem to have lost confidence in how the government is handling inflation. The University of Michigan subindex for consumers’ opinion of the government’s inflation policy recently fell to the low of 2022.

We note that sentiment data is often subjected to fluctuations that might not represent the true underlying strength or weakness of the economy.

We think gross domestic product will reach 1.5% in the first quarter, and the combination of uncertainty, slower growth and sticky inflation inside the service sector will create the conditions for stagnation at best and stagflation at worst.

Some of the latest data points in the consumer price index are likely to add to consumer wariness. Most notably, the service sector, with inflation at 4.1%, accounts for 63.78% of the overall CPI. Increases in that sector include 4.2% in the cost of shelter, 3.7% in your restaurant bill and 3.8% in the cost for personal services.

The most visible of price increases, however, remains the 58.8% rise in the price of eggs, which has more than overwhelmed the modest drops in gasoline prices and airline fares.

Those improvements in gas prices and airfares provide a quantum of solace within the top-line CPI figure. But sticky service prices and the threat of tariffs—which would put at risk a multiyear trend in goods disinflation—imply that the Fed faces limited flexibility in cutting rates.

One key fact is salient: 40% to 45% of all imports are inputs used to produce final goods inside the U.S. And the rise in the cost of those inputs  will end a multiyear disinflationary trend in goods, putting additional upward pressure on inflation.