Cool-Aid
After January’s hotter-than-expected inflation report, markets and consumers were crossing their fingers for a cooler read in February and got their wish. The headline Consumer Price Index (CPI) rose by 2.8% year-over-year and 0.2% month-over-month, below expectations of 2.9% and 0.3%, respectively. Core CPI also came in below expectations at 3.1% year-over-year, but remains well above the Fed’s target of 2%. Nevertheless, markets initially welcomed the cooler-than-expected data and rallied as a result. Investors have been whipsawed so far in 2025 on tariff developments and policy uncertainty, dragging broad indices and high valuation stocks down. This cool inflation print gives markets a much needed reprieve from the downside volatility, even if it’s short-lived and growth concerns continue to muddy the waters. One of the forces I’ve warned investors about is the beginning-of-year seasonality that can affect inflation prints. Simply put, inflation tends to come in hot in January — deemed the “January effect” — and can continue to surprise to the upside for the first quarter. For this reason, we like to track the non-seasonally adjusted data to get a raw read on what’s going on. As shown in the chart below, February’s non-seasonally adjusted CPI came in lower than 2023 and 2024, and very close to the pre-pandemic average. Also notable in this chart is the tendency for CPI to fall gradually as the year progresses. It’s too early in 2025 to say whether we’re decisively on that path, but this month’s reading is encouraging.
Under the Hood
Once again, we’re in an environment where consumers are talking about specific components of inflation on a daily basis. The hot topic of late has been rising egg prices, and it’s true that the category encompassing food at home has seen some bumpy data, but in February it actually came in flat, with other components offsetting the increase in egg prices. More interesting this time was the transportation category, which helped bring overall inflation down quite a bit. The concern over the past few months had been the rise in car insurance costs, which remains elevated, but yet wasn’t too problematic in February. As somewhat of a surprise, airfare fell quite a bit and helped cool the category, bringing transportation services down to -0.8% for February — a far cry from January’s +1.8% and the lowest reading since September 2021.
Of course we still have the problem of elevated shelter prices, but it’s nice to see one of the other problematic components cool off this time around. Baby steps.
Expectations > Events
As with most things market-related, expectations can be more important than the actual events. In this case, we track inflation expectations for short and longer term periods to gauge the market’s outlook on how things might change. The recent divergence between 1-year and 5-year expectations shown below is a direct result of trade policy uncertainty. Investors are expecting short-term inflation to rise due to tariffs, but longer-term inflation to fall if trade policy affects growth prospects over time.
There’s no definitive way to categorize the current expectations as “good” or “bad,” but I do think it’s safe to say that the increase in 1-year expectations coupled with inflation readings that remain above target will prevent the Fed from signaling or engaging in further cuts in the near-term.
With the next Federal Open Market Committee meeting coming up next week, it’s important to keep a watchful eye on this. The Fed gets concerned when higher inflation expectations become entrenched over longer periods, thus changing the way consumers and businesses spend and affecting the cost of living across the board. A rise in 1-year expectations doesn’t count as entrenched, and the gradual fall in 5-year expectations keeps this from becoming a major concern right now.
Trade policy continues to be a moving target, as do inflation expectations. Investors need to be careful not to get too excited about one cooler-than-expected data point and remain vigilant as the tariff conversations develop. But for now, let’s enjoy a short break in the action and a small inflation victory.
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