The Fed’s Preferred Inflation Gauge Sped Back Up

There was a moment, late last year, when everything seemed to be going according to the Federal Reserve’s plan: Inflation was slowing, consumers were pulling back and the overheated economy was gently cooling down.

But a spate of fresh data, including worrying figures released Friday, make it clear that the road ahead is likely to be bumpier and more treacherous than expected.

The Personal Consumption Expenditures price index — the Fed’s preferred measure of inflation — climbed 5.4 percent in January from a year earlier, the Commerce Department said Friday. That was an unexpected re-acceleration from December’s 5.3 percent pace after six months of relatively consistent cooling.

Even after stripping out food and fuel prices, both of which jump around a lot, the price index climbed 4.7 percent over the year through last month — also a pickup, and more than expected in a Bloomberg survey of economists.

Those readings are well above the Fed’s goal of 2 percent annual inflation. And the report’s details offered other reasons to worry. The previously reported slowdown in December, which had given economists hope, looked less pronounced after revisions. While price increases had also been consistently slowing on a month-to-month basis, they, too, are now showing signs of speeding back up.

Stocks slumped to their worst week of the year, with the S&P 500 down by 1.1 percent at the close of trading on Friday as investors digested the report and what it portends for the Fed, which has been raising rates aggressively since last year. Financial markets have come under sustained pressure in recent weeks as investors have recalibrated their expectations for how long inflation could remain high, and how high interest rates could go as a result.

The figures released Friday are just the latest evidence that neither price increases nor the broader economy is cooling as much as expected as 2023 begins. Employers added half a million jobs in January, wages continue to rise, and figures released Friday showed that Americans continue to spend freely on goods and, especially, on services like vacation travel and restaurant meals.

Fed officials in recent months have fended off criticisms, particularly from the left, that their inflation-fighting policies last year had gone too far and were threatening to push the economy into a recession. But the latest data point to a different question: whether the central bank will need to do even more to bring inflation to heel. In particular, many forecasters now expect policymakers to raise interest rates higher than the range of 5 to 5.25 percent that they previously anticipated.

“In a nutshell, it means the job is not done — in fact, it is far from done, because inflation is much too high,” said Gennadiy Goldberg, a rates analyst at TD Securities. “The economy is still strong, and consumers are still spending money.”

President Biden took a rosier view than financial markets, emphasizing the decline in gas prices and the strength of the broader economy.

“Today’s report shows we have made progress on inflation, but we have more work to do,” he said in a statement. “Annual inflation in January is down from the summer, while the unemployment rate has remained at or near a 50-year low and take-home pay has gone up.”

Fed policymakers have raised rates at the fastest pace since the 1980s over the past year, lifting them from near zero to more than 4.5 percent. The goal was to slow consumer demand and force companies to charge less, ultimately wrestling inflation lower.

There are hints that those efforts are having an effect, despite the hot start to 2023. The housing market has slowed sharply as mortgage rates have risen, and manufacturers, too, have pulled back. Even consumer spending, viewed over several months, has tempered somewhat from its furious pace earlier in the recovery.

But what had looked like a steady, albeit gradual, slowdown is now looking even more gradual, and not so steady. Personal spending, which fell slightly in November and December, jumped 1.8 percent in January, faster than inflation. Incomes rose as well, which could help keep spending strong in the months ahead.

The remarkable resilience of both consumers and the job market suggests that, despite the dour predictions of many forecasters, the economy is in little imminent risk of falling into a recession. But it could also make it difficult for the economy to slow enough that businesses charge less and inflation eases fully back to normal. That could, in turn, force the Fed to get even more aggressive — and increase the risk of a more severe recession down the road.

Officials signaled in December that they might need to ultimately lift rates to just above 5 percent, but those estimates have crept slightly higher in recent weeks as policymakers have reacted to surprisingly strong data on jobs and spending.

Mr. Goldberg said that Friday’s report was sure to spur speculation in markets that the Fed might speed up its rate increases, moving by a half-point rather than a quarter-point in March. Indeed, investors increased their bets for a half-point increase in March in the wake of the report, though expectations still tilted toward a quarter-point increase.

So far, officials have shown little interest in returning to larger rate increases, instead focusing on how high rates will climb and how long they will stay elevated.

Higher interest rates weigh on the economy by making it expensive for households to borrow to buy a car or a house, and by making it pricier for businesses to finance expansions. As those transactions stall, the aftershocks trickle through the economy, slowing not just the housing and automobile markets but also the labor market and retail and services spending as a whole.

But the full effect of policy takes time to play out, which makes it difficult for central bankers to assess in real time how much policy tightening is exactly the right amount to slow the economy and bring inflation to heel.

Fed officials will be parsing an array of data — on jobs, wages, spending and inflation — before their next meeting on March 21-22.

Officials have warned that rapid pay growth in particular could keep price increases stubbornly high, even as supply chains heal and once a recent pop in housing inflation begins to fade.

“The ongoing imbalance between the supply and demand for labor, combined with the large share of labor costs in the services sector, suggests that high inflation may come down only slowly,” Philip Jefferson, a Fed governor, warned in prepared remarks that discussed an academic paper on Friday.

That paper, by a group of prominent academic and Wall Street economists, used a model to predict that officials may need to raise interest rates much more — as high as 6.5 percent — and inflict economic damage in order to wrestle price increases under control.

“There is no post-1950 precedent for a sizable central-bank-induced disinflation that does not entail substantial economic sacrifice or recession,” according to the study.

Fed policymakers may also take a signal from recent earnings calls, which have suggested that the economy is beginning to lose some of its hotness, though it is still not fully back to normal. Corporate profit margins had expanded drastically, but could begin to stall out as firms find it increasingly difficult to charge ever-higher prices.

In 2022, “we observed a resilient customer who is less price sensitive than we would have expected in the face of persistent inflation,” Ted Decker, Home Depot’s chief executive, said on a call with analysts this week. But “we noted some deceleration in certain products and categories, which was more pronounced in the fourth quarter.”

Joe Rennison contributed reporting.