February CPI: Balancing price stability vs. financial stability as inflation remains elevated

REAL ECONOMY BLOG | March 14, 2023

Authored by RSM US LLP

Inflation in the United States accelerated modestly in February, increasing by 0.4% on the month and by 6% on a year-ago basis. It was a similar reading in the core number that excludes food and energy, with prices in that sector rising by 0.5% on the month and by 5.5% compared to a year ago, according to data released by the Bureau of Labor Statistics on Tuesday.

Inflation in services, though, was another story. While core service inflation excluding housing is moderating overall, service sector inflation overall and service sector inflation excluding energy remain hot and merit further rate hikes at next week’s Federal Reserve meeting.

But given the current stress in the banking system, the Fed may choose to delay a rate increase until May.

The underlying pace of inflation appears to be increasing between 4% and 5% while core services excluding housing is increasing at 3% on a three-month average annualized pace.

The increase in core inflation and inside the shelter component complicates efforts at the Federal Reserve, which must balance the need to restore price stability against efforts to restore financial stability in the wake of recent bank failures.

Policy implications

Based on our evaluation of the data, the Federal Reserve should strongly consider increasing the policy rate by 25 basis points next week.

That move is contingent on the maintenance of the current status quo, which has stabilized after a series of bank failures. Further bank failures, seizures by regulators or problems in large, globally important banks would most likely lead the Fed to temporarily pause its efforts to restore price stability.

Rising levels of financial stress, tightening financial conditions and severe volatility inside the fixed income markets all suggest a pause by the Fed. Events in financial markets until the meeting will most likely dictate the outcome of the Fed’s decision.

For now, we think a hike is in order. Inflation inside core services, which are linked to wage demands, continues to rise, so the economic rationale for hiking rates continues to flash red.

But we stress that our forecast is dependent upon conditions in financial markets not deteriorating further. And the announcement of the $25 billion Bank Term Funding Program on Sunday to ring-fence depositors tends to support the idea that the Fed will lean toward price stability in its policy decision.

A decision not to hike at the March meeting would most likely be interpreted by market participants as an acknowledgement by the Fed that its lending facility is not doing enough to restore financial stability.

The data

Service sector inflation increased by 0.5% in February and was up by 7.6% year over year. Services excluding energy increased by 0.6% and were up by 7.3% compared to a year ago.

Policy-sensitive metrics that track inflation inside housing all were still at elevated levels. Housing costs increased by 0.5% on the month and were up by 8.2% from a year ago. The cost of shelter increased by 0.8% and 8.1% compared to a year ago, and owners’ equivalent rent increased by 0.7%, and was up 8% over the past year.

Energy costs declined by 0.6% in February, gasoline prices increased by 1%, food prices advanced by 0.4%, and food and beverages increased by 0.35.

Apparel costs jumped by 0.8% and the cost of new vehicles advanced by 0.2% in February. The cost of medical care declined by 0.5% and the price of used cars and trucks dropped by 2.8% on the month. Arline fares increased by 6.4% in February.

The takeaway

Inflation is increasing between 4% and 5% while the cost of core services excluding housing is rising at a three-month average annualized rate of 3%. Overall, the data is moving in the right direction and implies that further relief on inflation later this year is developing. But elevated inflation in services continues to flash red, and we expect overall inflation to remain well above the Fed’s official 2% target throughout the year.

Since service sector inflation is strongly tied to wage pressures, the economic rationale for hiking interest rates is quite clear. That decision is going to be driven by the degree of financial stability that can be restored following the decisive action by the Federal Reserve to ringfence the deposits of Americans over this past weekend.