Chief Economist Eugenio J. Alemán discusses current economic conditions.
If there is something the Federal Reserve (Fed) does not want to see today, as it approaches next week’s Federal Open Market Committee (FOMC) meeting, it is a shock to oil prices. The reason for this is that it brings back memories of the 1970s and 1980s, when oil prices surged and contributed to higher inflation during those decades. But the similarities don’t end there. Some of the actors of the events that triggered the shocks to oil prices are also familiar and involve Israel and Iran.
However, we have come a long way from the 1970s and the 1980s, especially when it comes to the consumption of petroleum. The global economy does not depend as much on oil today as it did back in the 70s and 80s, and thus, a petroleum shock is not as impactful as it was during those decades. Of course, the total impact on petroleum prices is difficult to predict because it will depend on the evolution of the conflict between these two countries.
But the truth is that one of the most important contributors to lower inflation over the last year or so has been a decline in petroleum prices, and the current conflict will probably disrupt this trend. Thus, there is a high probability that Fed officials will be spooked and their risk aversion will increase, which means that monetary policy will probably remain restrictive for a longer period of time. That is, tariff as well as petroleum price uncertainty will definitely keep the Fed on the sidelines for next week’s meeting and could potentially reduce the probability that they will lower interest rates later in the year.
Under this scenario, the core PCE price index and the core CPI price index will be of utmost importance for the Fed. If headline inflation accelerates but core inflation remains contained, then the monetary policy path could remain intact. However, if we see both headline and core inflation moving up, then the prospects for lower interest rates are probably less likely.
Little inflation impact from tariffs, so far
This was a good week for inflation as well as for the Trump administration, as tariff-related impacts are still not popping up in the headline inflation numbers. We have seen marginal impact in some goods prices, but the emerging weakness in the service side of the economy is showing up in pricing power weakness, which is keeping overall inflation numbers contained—at least for now.
However, we have to add US dollar weakness to the threat of higher inflation from tariffs, as this weakness will make imports even more expensive and could add another layer of potentially higher prices going forward. On the flip side, this week’s attacks between Israel and Iran are showing up as an appreciation of the dollar, as investors seek less risk from current uncertainty, which could lessen the impact of the dollar on import prices.
Perhaps the biggest unknown remaining has to do with the state of economic activity. Last week, we saw the first sign of potential weakness in the service side of the economy, with the ISM Services PMI dropping into contraction in May, the first such reading since June of 2024. Furthermore, while both durable and nondurable goods prices were almost flat on a year-over-year basis in May, services prices continued to slow down, hitting 3.7%. That is, the underlying disinflationary environment continued, so far undisturbed from increases in tariffs.
It is still not clear if the lack of tariff-induced price hikes are the result of President Trump’s “eat tariff price increases” comments, the overall weakness in economic activity—which makes it difficult for firms to pass larger price increases to customers—still high levels of uncertainty regarding the future levels of tariffs which make it difficult for firms to know by how much they should be increasing prices, or a combination of all of the above.
What we do know is that whatever the reason is for the reduced impact from tariffs on the rate of increase in prices, this is going to cost firms considerably, as earnings will reflect these effects at some point during the year.
If these effects push firms to adjust their employment levels in order to reduce the impact on profits, then we can see some further economic weakness ahead. This is the reason why we are not changing our recession probability (50/50) as many shops have been doing lately. That is, we still believe that uncertainty about the future is problematic and has the potential to derail economic activity during the second half of the year.
Economic and market conditions are subject to change.
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Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.
Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.
Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.
The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.
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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.
Employment cost Index: The Employment Cost Index (ECI) measures the change in the hourly labor cost to employers over time. The ECI uses a fixed “basket” of labor to produce a pure cost change, free from the effects of workers moving between occupations and industries and includes both the cost of wages and salaries and the cost of benefits.
US Dollar Index: The US Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the
U.S. dollar gains "strength" when compared to other currencies.
Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).
ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.
Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households.
Producer Price Index: A producer price index(PPI) is a price index that measures the average changes in prices received by domestic producers for their output.
Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.
The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.
Conference Board Coincident Economic Index: The Composite Index of Coincident Indicators is an index published by the Conference Board that provides a broad-based measurement of current economic conditions, helping economists, investors, and public policymakers to determine which phase of the business cycle the economy is currently experiencing.
Conference Board Lagging Economic Index: The Composite Index of Lagging Indicators is an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.
New Export Index: The PMI New export orders index allows us to track international demand for a country's goods and services on a timely, monthly, basis.
Gold is subject to the special risks associated with investing in precious metals, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated.
The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.
Source: FactSet, data as of 12/6/2024
