It’s well-known that the dollar has been weaker because of a loss of confidence in the US economic outlook. But normally a slowing economy means inflation will come down as well. This allows the central bank to give the economy some support by cutting interest rates.
What has gotten some investors particularly concerned about the US is that inflation is not only above target, but is expected to remain high. That means the Fed might not be able to help the slowing economy, leading to a spell of something that most economists fear: Stagflation. Or worse, an outright recession, with the Fed’s GDPNow tracker still suggesting that the first quarter will see an economic contraction.
The Worrying Forecasts
The focus of last week’s FOMC rate decision was naturally around the interest rate. But what seems to have had more staying power in the market’s mind is the change in forecasts. The Fed cut its GDP growth rate forecast for this year to 1.7% from 2.1% that it had projected in December. But it also raised its forecast for inflation to 2.8% from 2.5%, well above the 2.0% target. The Fed wasn’t forecasting an all-out disaster, however, as it signaled inflation would remain relatively steady and end the year around 4.4%, which is generally understood to be below the structural level.
While slow growth and high inflation meets the definition of stagflation, the issue for the markets comes back to interest rates. If inflation stays above target, then the Fed can’t move to ease rates. In fact, it might even have to hike in order to push inflation down.
Agreeing on What Will Happen
The market is projecting two rate cuts, which agrees with a majority of the FOMC members. That, however, is based on a projection that even though headline inflation might remain high for transitory reasons, the core rate will continue to trend lower. The Fed acknowledges that tariffs are likely to have an impact on consumer prices. But that increase in prices is likely to be transitory, just like US Treasury Secretary Scott Bessent has been saying since the first tariffs were applied.
Therefore, markets are likely to not be so worried about the headline inflation rate. Rather the focus is likely to remain on the core rate and the performance of the economy. The Fed currently expects Q1 GDP in the US to contract by -1.8%, which implies a rebound later in the year to match forecasts. Markets are understandably worried that the dip will be deeper than expected. And that could very well be the case if the Fed’s preferred measure of inflation (core PCE price index) surprises to the upside. That might postpone the Fed’s rate cuts, which in turn means the expected second-half recovery might not materialize.
What to Look Out For
The consensus among analysts is that the US headline PCE price index will show the same change as last month, staying at 2.5% annual. That would conform to the expectation that inflation has peaked in the winter and will trend lower through the spring.
It’s with the core rate that there could be a little complication. The monthly figure is expected to show a modest acceleration to 0.4% compared to 0.3% prior. The annual US core PCE price index rate, on the other hand, is expected to rise to 2.8% from 2.6% prior, partially as a result of base effects. If it’s more than that, it could end up spooking the markets, and weakening the dollar once again.
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