Commentary: Inflation watch (only in the US)

Globally, inflation risks are muted. Demand is soft and the investment environment is facing uncertainties around trade wars. Sustained currency appreciation against the USD and a marked decline in commodity prices have added to the fading of inflation concerns. One major exception to that narrative is the US, which is facing a striking policy-induced upward risk to the price level.

Backward looking data do not pose much concern. US headline CPI and PCE inflation rates are tracking sub-2.5%, while core readings are at below-3%. These are not very comfortable figures by historical standards, but they don’t keep Fed policy makers up at night, we’re sure.

An economy that has grown robustly in recent years and has so far been blessed with a tight labour market can absorb 2-3% inflation with little friction. The easing of commodity prices, spanning the spectrum from fuel to food, so far this year, also helps the inflation narrative, especially at the headline level.  Even at the core level, Dallas Fed’s trimmed mean measures show encouraging developments.

“We may be entering a period of more frequent, and potentially more persistent, supply shocks—a difficult challenge for the economy and for central banks.”—Fed Chair Jerome Powell, Second Thomas Laubach Research Conference, May 15.

Backward data, however, are an inadequate reflection of underlying inflation risks in the US. As noted by Fed Chair Powell at a speech last week, policies undertaken by the Trump administration have led to a fundamental shift in price expectations. Recent favourable developments on China-US trade talks mask the fact that this year’s trade policy measures have taken US import tariffs to levels not seen since the 1940s. These tariffs, even if they settle with 30% on China and 10% on most of the world, along with assorted rates on selected sectoral imports, will contribute to margin compression for firms and/or price passthrough at the retail level. Thanks to on-again, off-again tariffs and other trade restrictions, there have already been episodes of sudden stop and resumption of orders and shipments. These are bound to affect sentiments and prices.

University of Michigan survey’s latest readings are dramatic. The recent jump in inflation expectation and correction in consumer sentiment coming out of the survey responses reflect crisis-type magnitudes. The fact that these shifts have yet to materialise in higher inflation or lower purchases should not be cause for complacency; it may well be just a matter of time. A combination of tight labour market and rising money growth would have caused some upside risk to inflation in any case. Combine this with trade war matters, and firms have a few excuses to raise prices in the near term.

The fact that weakness in commodity prices has not managed to dent inflation expectations or consumer sentiment is troublesome. Equally concerning is the fact businesses are already reporting a sharp rise in input prices. The survey readings reflect pressures akin to 2022, which was a time of much higher inflation. Regional manufacturers’ surveys warrant particular attention, as they are likely to be at the frontline of the tariff mayhem.

“Higher real rates may also reflect the possibility that inflation could be more volatile going forward than in the inter-crisis period of the 2010s.”—Fed Chair Jerome Powell, Second Thomas Laubach Research Conference, May 15.

Chair Powell’s observation last week that higher real interest rates than what was seen in the 2010s is likely going forward drew our attention. Long-term interest rates in the mid-to high 4% range may well be the outcome of higher inflation expectations, induced by policy volatility. But they would lead to steep yield curves and dampen equity and real estate prices, and hurt the consumption and investment outlook. If the Fed is serious about arresting a rise in inflation expectations, it would have to communicate a more hawkish stance, risking substantial pushback from President Trump and considerable near-term downside to asset prices.

Financial markets, particularly equities, have recovered a large chunk of their losses since the early-April mayhem, cheered by some recent progress in trade talks. We are not at all convinced by this rally though, as we see the risks to inflation and interest rates highlighted by the Fed Chair not being captured in the pricing.  We expect the summer reprieve to risk sentiments, helped by the 90-day pause in China-US trade war, to fade once the survey readings begin to get reflected in actual data. 

As risk markers, we will look at guidance from large retailers first, as they have the widest views on supply chain related matters. But for the US economy, perhaps equally critical is the situation with small businesses. As Chair Powell pointed out in his speech last week, potential disruptions to supply chains and distribution networks tend to be acute for small businesses, as their operations are less diversified, less able to access credit, and hence more vulnerable to adverse shocks.


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