Stubborn US inflation complicates Fed’s interest rate decision

NEW YORK – The latest inflation data released on Tuesday promised to make the US Federal Reserve’s interest rate decision next week even more fraught: Price increases showed signs of continued stubbornness, which would usually call for higher rates, but the data came as the turmoil sweeping the banking system has caused some economists to urge caution.

Price increases did cool slightly on an annual basis,

with the US consumer price index climbing 6 per cent over the year up to and including February, the Labour Department said on Tuesday.

That figure was down from 6.4 per cent in January, and matched the slowdown that economists expected. It seemed like an encouraging sign, but the underlying details of the report made the data more worrying.

Inflation looked far firmer beneath the surface. The price index climbed 0.5 per cent from the previous month after it was stripped of food and fuel prices – both of which bounce around a lot – offering a sense of underlying price pressures. That was up from 0.4 per cent in January and more than economists had forecast.

In fact, the increase was the fastest monthly pickup in the so-called core index since last September, which is not the kind of progress central bankers are hoping for a year into their fight against inflation. Many close Fed watchers anticipated that the central bank, which meets next week, would raise interest rates by a quarter-point in the wake of the data – a gradual move that would try to balance risks posed by rapid price increases with the threat of further financial instability as tremors shoot through the banking system.

“It’s a strong report,” Ms Priya Misra, global head of rates strategy at T.D. Securities, said of the inflation report. “It’s really hard for the Fed to respond by not hiking – or cutting, that’s crazy talk.”

The Fed had been awaiting this inflation report before its decision next Wednesday. Recent price, job market and growth data has suggested that the US economy is retaining more strength early in 2023 than expected.

Policymakers were looking to the consumer price index reading from February to try to understand whether the pickup was a blip caused by mild January weather – which tends to encourage consumer spending and construction – or a genuine signal that the economy might be regaining momentum.

Just last week, Fed chair Jerome Powell suggested that if the data came in hot, the US central bank might raise rates by half a percentage point at its meeting. That would have been a big shift: After raising rates rapidly in 2022, including four jumbo three-quarter-point increases, the Fed slowed its moves to a half-point last December and a quarter-point in January.

But in the span of a few days, the Fed’s decision has become enormously complicated. Three notable banks in the United States have blown up in the past week, a bout of turmoil that is partly the result of higher interest rates.

The collapse of Silicon Valley Bank (SVB) at the end of last week, followed by the seizure of Signature Bank just days later, spurred a sweeping government response meant to assure depositors that their money was safe to prevent bank runs from spreading across the country.

SVB’s demise tied back to the recent burst of inflation and the Fed’s rate moves to contain it. SVB held a lot of long-term government bonds that had declined sharply in market value amid the bout of unexpected price increases and the Fed’s responding rate moves. That squeezed its ability to sell the bonds to raise sufficient cash without realising big losses when customers pulled their money out.

Experts have been clear that SVB did a bad job of managing its interest rate risk, but there is a chance that other institutions across the financial system could find themselves in a similar boat.

And the question is whether the Fed can continue raising borrowing costs when rising interest rates could risk further financial instability.

The inflation number “was strong – in normal times these data would support a strong increase in the Fed funds rate”, said Nomura senior economist Aichi Amemiya. He had pencilled in a half-point increase before the bank blow-ups but said in their wake that he did not think the Fed would stick with a plan to push up borrowing costs.

Instead, Mr Amemiya expected the US Federal Reserve to lower rates at its meeting.

“If they mishandle the looming financial risks, that could affect the economy” too severely to merit the risk, he said.

Nomura’s call was an outlier. Investors heavily bet on a quarter-point rate increase next week, based on market pricing after the data was released.

Ms Misra said that if officials did not raise interest rates amid continued strong inflation, “it sends a different signal, like: ‘What does the Fed know?’” – and that could stoke nervousness among investors and depositors.

Still, the debate over what the Fed might do underscores that the path ahead for the central bank is uncertain and complicated as the institution tries to figure out which risk to focus on – the one to the financial system, or the threat that lasting inflation could leave price increases ingrained in the economy. NYTIMES