As U.S. inflation rises, is the worse still ahead?

Key Concepts

• Headline Inflation: The raw inflation figure reported by the CPI that includes volatile categories like food and energy.
• Core CPI: A measure of inflation that excludes volatile items (food and energy) to show the underlying trend.
• Backwardation: A market condition where the spot price of a commodity (like oil) is higher than the price of futures contracts, suggesting immediate supply concerns.
• Dual Mandate: The Federal Reserve’s responsibility to promote maximum employment and stable prices.
• FOMC (Federal Open Market Committee): The branch of the Federal Reserve Board that determines the direction of monetary policy.

Impact of the Iran Conflict on Inflation

Andrew Cesarz, a strategic income portfolio manager at Morgan Stanley, notes that the March US CPI data (headline inflation at 3.3%, up from 2.4% in February) reflects only the initial impact of the conflict in Iran.

• Energy Price Transmission: The current data does not fully capture the surge in energy costs. Cesarz expects these costs to "bleed through" to other sectors, specifically shipping and airfares, in the April report.
• Core CPI Resilience: Despite the headline spike, core services and core goods rose by only 0.2%. Cesarz views this as a positive sign, suggesting the Federal Reserve may not overreact to the headline print, as the underlying inflationary pressures remain relatively contained.

Energy Market Outlook and Consumer Impact

The "gloomiest forecast" involves a prolonged conflict leading to a sustained rise in oil prices.

• Consumer Strain: The low-end consumer in the US is already financially stressed. Higher energy costs are expected to erode discretionary income that was previously anticipated to come from tax returns.
• Policy Interventions: While the US has utilized strategic reserves to offset shortages, Cesarz argues that the most effective resolution is a diplomatic agreement in the Middle East. He suggests that a ban on energy exports would only be considered by the administration if the conflict escalates significantly.

Federal Reserve Policy and Labor Market Dynamics

Cesarz argues that the conflict has delayed, rather than canceled, the prospect of interest rate cuts.

• Labor Market Weakness: While one recent payroll print appeared strong, Cesarz points out that five of the last ten US payroll reports have been negative. He believes the labor market is gradually weakening, which will eventually force the Fed to prioritize its dual mandate.
• The "Data-Dependent" Approach: The Fed is expected to wait for a resumption in the deceleration of inflation and further evidence of a cooling labor market before cutting rates.

Leadership and Institutional Constraints

Regarding the potential entry of Kevin Warsh into the Federal Reserve, Cesarz emphasizes that institutional constraints remain:

• Coalition Building: Warsh will face the same challenges as Jerome Powell, requiring a consensus from the FOMC.
• Data-Driven Decisions: Regardless of leadership, the FOMC will remain tethered to incoming economic data. Cesarz notes that Powell was not inherently "hawkish," and any successor will similarly be bound by the necessity of seeing clear evidence of disinflation and labor market softening before initiating rate cuts.

Synthesis and Conclusion

The primary takeaway is that while the conflict in Iran has introduced a temporary inflationary spike via energy costs, the broader economic trend remains one of gradual deceleration in core inflation and a softening labor market. The Federal Reserve is expected to maintain its current course, waiting for the "noise" of energy-driven inflation to subside before pivoting to rate cuts in the latter half of the year. The ultimate trajectory of the economy depends on the duration of the geopolitical conflict and the subsequent impact on consumer discretionary spending.