Inflation in focus: Unpacking the March CPI report

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Maia Crook: Welcome to JP Morgan's Making Sense. I'm Maia Crook, senior research analyst on the global economic research team. I'm joined today by senior economist, Mike Hanson, to discuss the takeaways from the March US CPI report and where we see inflation going from here. Mike, thanks so much for joining us.

Mike Hanson: Thanks for having me.

Maia Crook: So let's get into it. The March CPI report showed headline inflation up 0.9% on the month, the largest monthly increase since early 2022. This was driven by an 11% jump in energy prices, a result of the supply shortages stemming from the Middle East conflict. Core inflation, which strips out energy and food, rose a more modest 0.2% on the month, with the year ago rate taking up to 2.6%. Mike, what were your biggest takeaways from the report?

Mike Hanson: Yeah, I think you highlighted what were the kind of the key things that we saw and that we were looking for. And the first is w- that there was a very large increase in energy prices. Uh, and that was really as expected given what's happened in the Middle East. And the second, and I'm sure we'll talk about this a little bit more in a minute, the core measure, which you, as you mentioned, excludes food and energy, was a little bit softer than we had anticipated. Um, but, you know, I, I would not take a strong signal from that at this point. Uh, you know, we are still concerned that you're likely to see some continued firmness on the inflation numbers, even outside of what's happening with, uh, the energy numbers.

Maia Crook: And on the energy front, how are the data tracking so far for the month of April?

Mike Hanson: Yeah, so I think it's useful to put this in context. The most important input for energy CPI is gasoline prices, not surprisingly. And those that average about $2.93 in February before they jump to $3.71 on average for March. And for April, we're about a week and a half in. We're tracking a little bit more than $4.10 a gallon. So you're gonna continue to see some upward movement there. We're tracking roughly a little bit shy of two and a half percent. So obviously not the 11%, which I would say we did nail, uh, in terms of the forecast, but it's still, uh, a bit of an add. You're gonna see prices come off a bit from the $100 per barrel plus prices you're seeing right now, but they're almost certainly gonna remain elevated relative to where we were before the conflict began.

Maia Crook: And the Middle East conflict is also raising prices for a number of other commodities that would normally be flowing through the Strait of Hormuz. An increase in fertilizer prices in particular is raising concerns for upside risks to food inflation. Were there any signs of that in the March report?

Mike Hanson: I think the short answer is no, and that's not surprising because the feed through from fertilizer prices into food prices takes some time. Uh, in particular, it might not show up until the next growing season. But we saw specifically, if you look at food at home, which is effectively groceries, uh, that actually was down 2/10, uh, on the month. Food away from home, which is restaurants and the like, and, and really reflects much more the cost of labor, uh, and the cost of advertising, the cost of renting the, the space, uh, and not the raw food input, that was up 2/10. So you're very hard-pressed to see a big jump in food, certainly nothing like what we saw in energy.

Maia Crook: Gotcha. And now stepping towards core inflation, which strips out energy and food prices, this is obviously what the Fed targets when they're setting their policy rates. Was there any evidence that higher energy prices were feeding through into core inflation last month?

Mike Hanson: Yeah, so I think it's worth highlighting, um, central bankers do eat and drive. So they do pay attention to headline, as well as core. But the reason for focusing on core, uh, amongst economists widely, whether they're, you know, working in a central bank or, or working at a place like JP Morgan is that the volatility, certainly we've seen recently in things like food and energy prices is typically not representative of where inflation's going over the medium term. Um, so with that context, you didn't actually see, I would say, a lot of clear evidence that energy prices were feeding through. The one place where you see it most immediately is in the price of airfares. That was up, uh, 2.7% on the month. And that sounds like a strong number, but over the last several months, it's been higher than that on average because you've just seen a real, uh, post-pandemic reopening surge in demand for travel, particularly I think amongst higher income households. Uh, and so that number has actually been even firmer in recent months. So it's not clear that you were getting a big pass through effect right away. The other place you might think about where there could be pass through is in like shipping costs, and then that would show up in goods prices. But again, probably a bit of a lag, uh, and that's gonna make it, and we're, I'm sure we'll talk about this, a little bit harder to disentangle what part of higher goods prices might still be the pass through from tariffs as opposed to what might be shipping costs. But it's important to recognize that higher gasoline prices in particular are a drag on consumers' purchasing power. And so you're gonna substitute a way for demand for other goods and services to pay for your gasoline because demand is what economists call pretty inelastic. It doesn't really react to the price. You're gonna pay whatever you have to pay to get to work or to, you know, run the kids to school, get groceries, et cetera, uh, which means you're gonna cut back elsewhere. And weaker demand does put downward pressure on inflation all as being equal. So these things tend to offset. If you look at studies, uh, over longer periods of time, there's not a lot of evidence of pass through into core. So we'll have to, of course, monitor it in the current situation. But the fact that you didn't see really clear evidence of it this time is not that surprising.

Maia Crook: Okay. And you mentioned, um, the impact of tariffs.

Mike Hanson: Mm-hmm.

Maia Crook: Now, before the conflict, we had been tracking this, the impact, uh, on core goods prices specifically.

Mike Hanson: Mm-hmm.

Maia Crook: Back in February, if, uh, people can remember pre-conflict times, the Supreme Court decided to repeal IEPA. That lowered the effective tariff rate from around 10% to closer to 7%, but you and the team have been arguing that tariffs are continuing to pass through to inflation and push up core goods prices. Did we learn anything new on that front?

Mike Hanson: Arguably, no, we didn't learn anything new. Uh, core goods prices were actually a little bit soft, I think, relative expectations, up about two tenths on the month. We've seen a lot of communication though from, uh, tariff impacted businesses that, this year, they will likely continue to pass through some of those costs onto consumers. So that's the main reason we think that we're probably not yet done with those tariff impacts, but it could very well be gradual, uh, and there's going to be obviously this challenge where demand for other goods outside of energy could be somewhat softer, and that may limit the ability for firms to pass through tariffs quite as extensively as we might have first thought. I think in the end, whether it's an energy price pass through or a tariff price pass through, we're probably still gonna get something there.

Maia Crook: Mm-hmm. Okay. And turning to the other component in core, services inflation, um, and I wanna specifically focus on core services X shelter-

Mike Hanson: Mm-hmm.

Maia Crook: ... or so-called supercore, which is often used as a measure of underlying inflation pressures. That's been uncomfortably sticky in recent reports. Was there anything in this basket that stood out to you in March?

Mike Hanson: I would argue the thing that was most interesting in the March print was the dog that didn't bark through medical inflation, which was not as high as you might've thought. If you looked at the increase in, uh, prices for physicians and other professional medical services, that was up 5/10, and that's a decently firm number. And hospitals, uh, were up a, a softer 2/10, but the number overall in medical I think was weaker than a lot of people were expecting because of this kind of funky way for, (laughs) the technical term, for how we measure, uh, medical inflation in the CPI.

Maia Crook: Okay. Gotcha. And last week, we also got PCE inflation data for the month of February. PCE is the Fed's preferred inflation measure, and it's been running well above CPI lately. Uh, core PCE is running at a roughly four and a half annualized pace versus the 3% pace in core CPI. What's been driving the gap between these two measures and how does the Fed square these two differing signals?

Mike Hanson: Yeah, great question. So just to remind folks who may be a little less familiar with some of the, the lingo, the PCE is the personal consumption expenditure deflator, and it's really a broader measure in some sense of the prices that are affecting consumers. The CPI measures effectively just out-of-pocket expenses. Uh, the PCE, on the other hand, is all expenses on behalf of consumers. So if your firm is paying for your medical care or if you're getting some, uh, say public assistance or charity, those are included in the PCE, but not in the CPI. That's not the source of the difference though. What's really interesting is I think a lot of people have been presuming that services is the key difference, and the logic is half correct. So part of it is this idea that you're seeing a really significant slowdown in shelter inflation, and shelter has more than twice the weight in the measurement of the CPI versus the PCE. And so, uh, if it's coming down, it's gonna make PCE look higher than CPI. I think there's some truth to that, but I think that case is overstated. Uh, I don't think it's coming down quite as quickly as some people have been expecting or hoping. Uh, another piece is medical care. And again, insurance plays a bigger role here, and it does look like insurance costs are probably higher in the, in the PCE than the CPI. But if you just do a simple goods versus services split, the big difference is largely in goods. Uh, and there's some weird idiosyncratic things. So software is growing at, uh, 10 or 20 times in the PC, what is in the CPI. And we've asked the, the Bureau of Labor Statistics to explain that and we haven't really quite figured that one out just yet. Um, and there's a handful of other things. A- auto prices have a, a larger share in the CPI versus the PCE, and auto prices surprisingly, despite the tariffs, have actually generally been coming down. So that will also make the PC look a little bit firmer. So it's a, it's a range of things, to be perfectly honest. It's not one simple thing. Um, it's not the obvious smoking gun that some people point to, um, but it could persist, and that will be relevant for the Fed because the Fed does think that PCE is the better measure of inflation when push comes to shove. That's after all why they're targeting it. Uh, and with that running pretty firm, uh, and likely to remain, you know, well above the Fed's 2% target for the foreseeable future, it does put a lot of caution into Fed officials around the inflation outlook, particularly now that we've run five plus years of inflation well above target. Uh, I think Fed officials are cautious about letting inflation persist at a high level for such a long period of time because it gets embedded in inflation expectations, and then it becomes much more difficult and potentially much more costly to ring inflation out of people's expectations.

Maia Crook: I see. So CPI is more timely, but in terms of Fed implications, we should be looking to the PCE?

Mike Hanson: I think that's right. I mean, you know, the Fed always looks at every day that they can get their hands on.

Maia Crook: Sure.

Mike Hanson: 'Cause it's, you know, there's never one measure that tells you the, the whole truth about the economy.

Maia Crook: As do we.

Mike Hanson: (laughs) Indeed, as do we. But I would say that the PCE is the one that they are most focused on when it comes to inflation.

Maia Crook: Okay. And now, putting this all together, what's the inflation outlook for the rest of the year?

Mike Hanson: Right. So we typically think of inflation in, uh, 12-month changes or kind of year ago changes, and that's how it's typically recorded, because it can be volatile from month to month. And if we think about, uh, over the four quarters to the end of this year, we are currently looking for headline CPI inflation, which includes food and energy, to be running about 3.5%, uh, and core to be a little bit below that, just to touch below three. PCE is gonna be very similar, within a 10th. So I think three, four-

Maia Crook: Okay.

Mike Hanson: ... for the, the headline, and three for, uh, the core measure. So again, three is not two, and so that is a challenge for the Fed, for sure.

Maia Crook: Okay, gotcha.

Mike Hanson: Maia, let me turn the question over to you for a second in terms of the March inflation data. The US obviously had a very strong headline number, but maybe a little more moderate core. What are we seeing elsewhere in other, particularly developed markets on the inflation numbers for March?

Maia Crook: Well, I will caveat and say that as of recording, we have very limited data for the developed markets, but globally, March, uh, inflation is kind of a similar story as to the US. Globally, uh, March headline inflation is tracking a 0.7 increase, uh, the largest monthly gain since 2022. Just like the US, the global headline number was pushed up by a jump in energy prices, which will likely push inflation up to a roughly 5% annualized pace this quarter. That said, we are encouraged by the fact that core inflation remained broadly steady. Global core prices are tracking a roughly 0.2% increase last month. That's keeping the underlying pace of inflation around 3% annualized. That should give central banks some comfort and allow them to move cautiously as they balance these dual-sided risks to growth and inflation from the Middle East conflict.

Mike Hanson: Great. So we talked a bit about the Fed and how it might react. What are we thinking about how other central banks will react to the inflationary impulse coming from events in the Middle East?

Maia Crook: Yeah. So globally, our central bank calls are broadly less hawkish than market expectations. In the EM, the fact that the Fed is expected to remain on hold is actually giving other central bankers space to remain patient, keeping rates on hold while keeping an eye on core inflation and inflation expectations. The story is different in Western Europe, where we broadly expect hikes as central banks have expressed greater concern around second round effects on inflation and around an impact of higher energy prices on inflation expectations. And Mike, as I mentioned, uh, the Fed outlook is quite an important input for a lot of central bankers, particularly in the EM. So bringing it back to you, what is the Fed outlook for the rest of the year? How do we think they'll balance these upside risks to inflation from higher energy costs with the downside risks to growth from a purchasing power squeeze?

Mike Hanson: It's a great question. I think it comes down to timing and then magnitudes. So if the oil supply disruption were to clear up relatively quickly, then you wouldn't have that much of an inflation shock, and you wouldn't have that much of a purchasing power shock, and the Fed could probably largely look through that because the inflation shock would be temporary, right? So, um, even if energy prices, say, settle at $100 a barrel for oil and $4 a gallon for gasoline, once you've settled and you stay there for a while, you're not adding to inflation, of course, inflation is the rate of change, so the inflation impact tends to be very front loaded, very immediate. And then even if prices remain elevated, and that could, of course, weigh on purchasing power, it doesn't really add anything else to inflation.

Maia Crook: Mm-hmm.

Mike Hanson: But the longer that we remain with elevated prices, the more the purchasing power hit to consumers really starts to matter. And I think that's where the Fed is gonna have their focus. If we continue to see elevated costs for energy and perhaps some other goods because of the conflict in the Middle East, the concern over time for the Fed will be building around weakness in consumer demand. And ironically, perhaps that's ultimately disinflationary, right? If people are buying less stuff, the firms will not have the ability to hike prices nearly as, as rapidly as, as they might otherwise. So I think for Fed officials, it comes down to seeing how long does the shock last, how high the prices get, and try to get their handle around, or get a handle around how big of a drag on consumers it is. But that latter one is probably the dominant one. So in the debate whether the Fed should be hiking or cutting in response to an energy shock, unless the Fed loses credibility and inflation expectations become unhinged, like we hinted at earlier, it's probably more likely the Fed's gonna be worried in a sustained shock environment about the downside risks to growth, and therefore is likely to consider whether they might need to cut rates to cushion that shock to consumers.

Maia Crook: Well, Mike, we've covered a lot. Um, I think that's a good place for us to wrap up. Thank you so much for your time.

Mike Hanson: Thank you.

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