Has the Fed Misjudged Inflation?
Published: March 14, 2025 | 13:22
An analysis by BMO Capital Markets economists examines whether the Federal Reserve has accurately assessed the current inflation situation in the U.S., considering factors like underlying trends, inflation expectations, labor market conditions, and the potential impact of tariffs.
Key Takeaways
- The underlying inflation trend is meaningfully above the Fed's 2% target.
- Inflation expectations are showing signs of moving in the wrong direction.
- Labor market conditions are likely not a primary driver of price pressures.
- Tariffs are expected to initially raise inflation.
Detailed Analysis
1. Underlying Inflation Trend
An examination of six core measures of inflation suggests that the underlying rate is hovering about one percentage point above the 2% target. Progress toward the target has been slow, even before considering the potential impact of tariffs.
While services inflation is gradually decreasing, goods deflation is beginning to reverse. This upturn in goods prices may reflect businesses raising prices in anticipation of tariffs.
2. Inflation Expectations
Surveys from the University of Michigan and the Conference Board indicate recent spikes in households' inflation expectations. This increase may be driven by fears of a prolonged trade war. If these expectations feed into wage-setting and pricing behavior, the Fed could face a more significant challenge.
3. Labor Market Conditions
The unemployment rate has stabilized at 4.1%, slightly below the FOMC's neutral estimate. Labor market conditions remain healthy based on job openings and consumer survey reports. However, there are signs that the labor market is loosening, with increased layoff announcements and a rise in the underemployment rate. As a result, wage increases are slowing, and unit labor costs are aligned with price stability.
4. Impact of Tariffs
Tariffs are expected to raise inflation, with consumers likely bearing a significant portion of the cost. It is estimated that tariffs on Mexico, Canada, and China could raise core PCE inflation by 0.7 percentage points, potentially reaching 3.3% by year-end. However, if labor market conditions continue to loosen, core inflation is expected to return to current levels by mid-2026.
The Fed's Balancing Act
The Fed faces a delicate balancing act, navigating higher inflation on one side and slower growth on the other. Uncertain trade policies create risks that could lead to policy missteps.
Economist Contributors
- Sal Guatieri, Senior Economist and Director
- Douglas Porter, CFA, Chief Economist and Managing Director
- Michael Gregory, CFA, Deputy Chief Economist and Managing Director
- Benjamin Reitzes, Managing Director, Canadian Rates & Macro Strategist
- Scott Anderson, Ph.D., Chief U.S. Economist and Managing Director
- Jennifer Lee, Senior Economist and Managing Director
- Priscilla Thiagamoorthy, Senior Economist and Vice President
- Shelly Kaushik, Senior Economist and Vice President
Related Research
- 03/07/2025: Canada: Trade Alternatives amid American Tariffs (Michael Gregory)
Disclaimer
BMO Capital Markets is a trade name used by BMO Financial Group. The opinions, estimates, and projections in this report are those of BMO Capital Markets as of the date of the report and are subject to change without notice. BMO Capital Markets makes no representation or warranty, express or implied, regarding the contents and accepts no liability for any loss arising from the use of this report.