Why slower but stubborn inflation keeps the Fed on track for rate hikes

A slight February decline in inflation is keeping the Federal Reserve on track to boost interest rates next week despite a series of bank failures prompting concern about the central bank’s fight against rising prices.

Consumer prices rose by 0.4 percent in February and 6 percent over the past 12 months, right in line with what economists had been expecting, according to consumer price index (CPI) data released Tuesday by the Labor Department.

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The 6-percent annual inflation rate was the lowest yearly price increase since September 2021. It was down from 6.4 percent in January and high of 9.1 percent last June.

Without food and energy prices, which are more volatile, the “core” CPI rose 0.5 percent in February and 5.5 percent over the past 12 months—an unwelcome increase for the Federal Reserve, which is attempting to bring inflation back down to 2 percent annually.

But overall, the latest numbers are likely to keep the Fed’s rate-setting committee on track to raise rates by 0.25 percentage points at its upcoming meeting on March 21-22. 

“The Federal Reserve will most likely prioritize financial stability as the more immediate concern relative to inflation, balancing these issues by enacting a quarter-point hike while extending the timeline of its overall tightening cycle,” economist Noah Yosif of the National Association of Federally-Insured Credit Unions wrote in a Tuesday analysis.

Inflation figures boost chances of March rate hike

The Fed had been processing an uptick in the personal consumption expenditures (PCE) price index along with a mixed jobs report from last week before the collapse of Silicon Valley Bank and Signature Bank over the weekend.

The Fed had been signaling another interest rate hike leading into the March meeting after a sturdy February jobs report and stubborn PCE inflation and did not rule out a larger 0.5 percentage point hike.

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But the dual bank collapse prompted concerns among some market participants about whether the Fed had already dialed up enough pressure on the economy. 

In response to the bank failures, the Fed created a new lending facility backed by the U.S. Treasury to help make sure other banks wouldn’t follow suit and become insolvent.

Silicon Valley Bank held a large number of interest-rate sensitive U.S. bonds, which it was forced to sell at a loss after depositors started withdrawing funds, leading to the bank’s collapse.

Markets took a dive on the news Monday morning before rebounding on the hopes that the Fed would interpret the failures as a sign to cease further rate hikes. 

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That trend continued on Tuesday, with the Dow Jones Industrial Average of big U.S. companies jumping more than 450 points in morning trading.

Regulatory authorities are watching to see how far the failures will ripple throughout the rest of the financial sector, but Tuesday’s CPI is a good indication of the underlying health of the economy.

The Fed now has an 89 percent chance of sticking with a quarter-percent rate hike at its next meeting, according to the CME FedWatch prediction algorithm.

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Economists noted that prices in core commodities were unchanged on the month and that service inflation was also mild.

“Core goods prices were flat – and essentially unchanged over the last six months – while services [excluding] energy and shelter costs increased a mild 0.3 percent,” EY chief economist Gregory Daco wrote in an analysis.

Food prices, which hit consumers hard, are still running well above the headline number at 9.5 percent annually. Groceries are up 10.2 percent on year, while cereals and bakery products are up 14.6 percent from where they were a year ago on an unadjusted basis.

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That’s much higher than the international average, which puts cereal prices at only 1.4 percent above their level last year, according to the United Nations Food and Agriculture Organization, despite knock-on effects from the war in Ukraine.

A main driver of the inflation that remains in the economy is coming from shelter, which is up 8.1 percent on the year and accelerated to 0.8 percent on the month.

“[This is] tied for the largest monthly increase since the mid-1980s – with rent prices up 0.8 percent and owners’ equivalent rent up 0.7 percent,” Daco wrote.

Still, Daco said, “the bumpy disinflationary process is well underway, and current economic and financial conditions could accelerate the dynamics.”

What will the Fed do next?

Wall Street seemed assured by midday Tuesday that the Fed is on track to raise rates by a quarter of a percentage point at its next meeting. Some economists agreed that the Fed couldn’t afford to let up in its fight against inflation.

“Core CPI came in hot,” Jason Furman, chairman of the White House Council of Economic Advisers under former President Obama, wrote online Tuesday morning. 

“A Fed pause would exacerbate financial stability risks [and] lead to more/faster hikes later,” he continued. 

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Even so, other left-leaning economists urged the Fed to hit the brakes after eight months of annual inflation coming down.

“It’s obvious that millions of people don’t have to lose their jobs to lower prices. Chair Powell and the Fed need to stop raising interest rates before they trigger a painful and unnecessary recession,” economist Rakeen Mabud of the Groundwork Collaborative, a progressive nonprofit, wrote in a statement. 

Is the Fed’s rationale correct?

Some economists have pointed out that the current inflationary cycle isn’t following the pattern of the last period of high inflation in the late 1970s, when a so-called wage-price spiral took hold and resulted in a more uniform rise in prices.

Rather, in the aftermath of pandemic shutdowns, different price pressures are ebbing and flowing in distinct parts of the economy, they argue.

“We saw a big rise in durable goods and autos in 2021, and we saw a big rise in the price of energy and food following the invasion of Ukraine and most recently we’ve seen a rise in the price of housing,” John Jay College economist J.W. Mason said during an online event earlier this month. 

“These things have really had their own separate timing and their own separate dynamics,” he said.

For that reason, some economists are worried that more interest rate hikes by the Fed, which can prompt companies to shed workers and increase the unemployment rate, are the wrong path. Annualized wage growth slowed to just 3.6 percent over the last three months, according to Labor Department.

“Recent wage growth [doesn’t] suggest a lot of labor market pressure,” University of Massachusetts Amherst economist Arin Dube wrote online on Tuesday.

Updated at 1:10 p.m.