Creating Dilemma for Fed

• Inflation remained high in February, with the CPI up 0.4% and the core CPI up 0.5%.
• Services, particularly housing, are leading inflation.
• PNC expects the FOMC to raise the fed funds rate by 25 basis points at its meeting next week. But recent bank failures have made the Fed’s job even trickier.
• PNC expects inflation to slow in 2023 and 2024 as the U.S. economy experiences a mild recession.

The consumer price index rose 0.4% in February from January, according to the Bureau of Labor Statistics, matching the consensus expectation. This followed a 0.5% increase in January. On a year-ago basis overall CPI inflation (not seasonally adjusted) was 6.0% in February, down from 6.4% in January and a cyclical peak of 9.1% in June. 

The core CPI, excluding food and energy prices, rose a big 0.5% in February, up from 0.4% increases in December and January. Year-over-year core CPI inflation (not seasonally adjusted) was 5.5% in February, down from 5.6% in January and a cyclical peak of 6.6% in September. 

Inflation is slowing, but not quickly enough for the Federal Reserve. In isolation, high inflation in February, along with the strong jobs report, would point to at least a 25 basis point increase in the federal funds rate when the Federal Open Market Committee meets next month, and perhaps a 50 bps increase. But the FOMC may turn more cautious with the recent collapses of Silicon Valley and Signature banks. PNC’s expectation is that the FOMC raises the fed funds rate by 25 basis points on March 22, but there is a possibility that the FOMC keeps the rate unchanged, or even cuts it. 

The central bank has set an inflation objective of 2%, using a different price measure, the personal consumption expenditures price index. Through January PCE inflation, both overall and core, was running far above 2%, and the February CPI report indicates that PCE inflation will remain elevated. The FOMC has been raising interest rates in an effort to cool off economic growth and slow inflation. In particular, the very tight labor market has contributed to strong services inflation, although wage growth has slowed somewhat in recent months. 

What was a tricky task for the Fed, raising rates by enough to cool off inflation, but not by too much as to push the economy into recession, has gotten even more difficult with the recent bank failures. The big increase in interest rates over the past year is exposing stresses in the financial system. 

PNC expects that the cumulative impact of Fed monetary tightening will push the U.S. economy into a mild recession starting in the second half of this year. That, in turn, will lead to a significant slowing in inflation in late 2023 and in 2024, pushing it back to the FOMC’s 2% objective by the middle of next year. 

Inflation remains concentrated in services. Services prices, excluding energy, increased 0.6% in February, including a 0.8% increase for shelter (primarily housing). Food prices rose 0.4%, with grocery store inflation slowing. Energy prices were down 0.8%, with big drops for heating oil and natural gas, but an increase in gasoline prices. Used car prices fell almost 3% over the month, even as new car prices were up slightly.