Originally written on 2/18/2025

Last week’s consumer price index report (CPI) was bad news for the economy. The Labor Department’s all-item 12-month price index rose 3.0%. Not only is this well above the Federal Reserve’s target of 2.0% for annual inflation, it is the 4th consecutive month the inflation rate has risen. After trending down to 2.4% in September 2024 from 3.5% in March 2024, the inflation has increased since Fall 2024. Of course, all economic data is flawed, so the CPI statistics may be a fluke. However, the odds of drawing four black balls out of a tub containing half white and half black balls is only about 6%. So, the results are not likely to be too far off. 

Other indicators also signal that inflation has not been tamed and may rise. The St. Louis Federal Reserve’s 5-year break-even expected inflation measure, derived from the difference in yield from inflation-indexed and non-indexed bonds, fell below 2% in August 2024. We had all hoped this was a sign inflation had been tamed by the Federal Reserve’s previous policy of setting short-term rates as high as 5.5%. The Federal Reserve apparently also thought so and cut interest rates in September by a half-percentage point and then by another quarter percent in both November and December. 

However, the St. Louis Fed’s inflation expectation measure broke the 2% mark on September 19th, perhaps not coincidentally the day the Fed cut interest rates, and continued to rise to 2.46% on November 6th, the day after the Presidential election. It stayed relatively stable until January 6th, when the Electoral College certified the Presidential results, and then rose to 2.62% in our most recent reading.  

Inflation is likely to remain stubborn since there are numerous potential sources for price increases. An aggressive tariff policy increases the prices of both domestic and imported goods because American producers face less competition from foreign competitors, and many imports are inputs for domestic goods. In either case, American producers will increase their prices. In addition, trade wars, regional conflicts, and unpredictable fiscal and monetary policies lead to inflation uncertainty, typically reducing investment and American industrial production.  

The only guaranteed way to whip inflation now is for the Fed to raise interest rates immediately and significantly. But that would almost certainly trigger a recession. While we seriously doubt the Fed will raise rates anytime soon, they will probably not cut interest rates again in 2025.