The inflation indicator most favored by the Federal Reserve cools down, but under the heavy pressure of tariffs, the market is hotly discussing "stagflation."

According to the Zhitong Finance APP, the Federal Reserve's preferred inflation indicator—the so-called "Core Personal Consumption Expenditures Price Index" (Core PCE)—showed a moderate increase in January. This comes as a series of economic data reports indicate that price pressures in the U.S. are heating up again, while reduced consumer spending may lead the U.S. economy into a downturn. The indicator provides some relief to concerns about "inflation returning."

However, the PCE report shows that the decline in consumer spending exceeded expectations, which may raise concerns about the resilience of the U.S. economy. With recent economic data overall indicating persistent inflation, alongside weak consumer spending, a significant cooling of business activity, and unusually low consumer confidence, the market has begun to discuss the possibility of "stagflation" in the U.S. After the release of the PCE data, expectations for a Federal Reserve interest rate cut showed no significant changes, with the market still betting on 1-2 rate cuts this year.

Data released on Friday showed that the so-called Core Personal Consumption Expenditures Price Index (excluding food and energy items), or Core PCE, rose 0.3% month-on-month in January, in line with economists' expectations but slightly higher than December's month-on-month growth of 0.2%, indicating a slight warming of the month-on-month benchmark.

The PCE data report released by the U.S. Bureau of Economic Analysis on Friday also showed that compared to the same period last year, the Core PCE index rose 2.6% year-on-year, consistent with market expectations, marking the smallest annual increase since early 2021. Additionally, the year-on-year growth of the Core PCE in December was revised up from 2.8% to 2.9%, indicating a cooling of the U.S. Core PCE index on a year-on-year basis.

For the fundamentals of the U.S. economy, the unfavorable news is that inflation-adjusted consumer spending unexpectedly fell 0.5% month-on-month, marking the largest monthly decline in nearly four years. Economists had expected a month-on-month growth of 0% or a slight decline of 0.1%. As extreme cold weather intensified from late December to January, consumer spending in the U.S. seems to have become cautious after an unexpectedly strong holiday shopping season.

The latest PCE data report indicates that the unexpected decline in consumer spending was driven by a decrease in automobile purchases and durable goods purchases. However, as data shows a slowdown in service spending, it may further catalyze market concerns about the resilience of the U.S. economy, given that consumer spending accounts for as much as 80%-90% of U.S. GDP. Other data from the PCE report shows that the overall PCE, including energy and food, grew 2.5% year-on-year, consistent with economists' expectations, down from a previous value of 2.6%, indicating a slight decline in overall PCE; the overall PCE rose 0.3% month-on-month, in line with market expectations and the previous value.

Looking ahead to the Federal Reserve's progress in combating inflation, it remains to be seen to what extent ongoing price pressures, combined with aggressive policy changes including new tariffs on imported goods, will impact consumers. However, data released on Friday already indicated that spending on services, which accounts for the majority of personal consumption expenditures, showed weak growth last month.

With the latest PCE data report showing a significant decline in consumer spending enthusiasm, and previously released economic data indicating weakness in business activity, consumer confidence, and unemployment claims, the latest inflation expectations from the University of Michigan for February revealed that U.S. consumers' 5-year to 10-year inflation expectations rose to 3.5%, marking the largest month-on-month increase since May 2021 and the highest level since 1995. U.S. consumers are increasingly concerned that Trump's tariff hikes will lead to rising prices, and they worry that companies may significantly cut jobs due to inflation and the Federal Reserve's high interest rates, which could lead them to anticipate a substantial reduction in consumer spending. Consumer spending has been a strong core driver of the U.S. economy since the Federal Reserve's aggressive rate hike cycle began in 2022.

More significantly, with Trump officially announcing that starting next Tuesday, the U.S. government will impose a 25% tariff on goods from Mexico and Canada, and an additional 10% tariff on Chinese imports, concerns about a new round of global trade wars are intensifying. An increasing number of economists and Wall Street strategists are beginning to discuss the possibility that the U.S. economy may soon fall into the most challenging economic dilemma for the Federal Reserve to resolve—stagflation.

Core PCE shows U.S. inflation cooling, but other economic data suggests inflation may return

Despite this, Friday's PCE data report provided a breather for the Federal Reserve in its fight against inflation. Previous reports on the prices of other goods indicated that the Fed's progress in combating inflation has not only stalled but has also reversed upward, raising market concerns that the inflation beast may make a complete comeback.

The previously released January CPI rose by 0.5% month-on-month, marking the largest increase since August 2023. The overall CPI in January showed a year-on-year increase of 3%, the largest increase since June 2024, and the January CPI significantly exceeded economists' expectations both month-on-month and year-on-year. The so-called "Producer Price Index" (PPI), which measures final demand, rose by 0.4% month-on-month in January, and the December PPI inflation was revised to a month-on-month increase of 0.5%. Compared to the same period last year, the PPI increased by 3.5%, exceeding the market's general expectation of 3.2%.

Federal Reserve officials have generally indicated that they need to see a clear easing of inflation before considering resuming the rate-cutting process, especially given the uncertainty of how Trump's tariffs and domestic tax cuts will affect prices. "I believe monetary policy can remain patient when assessing the future path, which may mean keeping the federal funds rate unchanged for a period of time."

Cleveland Federal Reserve Bank President Loretta Mester stated on Thursday that she expects the Fed's policy rate to remain unchanged temporarily, as the market seeks evidence that inflation pressures are receding to the 2% target. Mester also indicated that she would seek more evidence of price pressures returning to 2% before supporting rate cuts, as long as the U.S. labor market remains healthy But she warned that "while there is ample reason to expect inflation to gradually fall to 2% in the medium term, this is far from certain, and there are significant upside risks to the inflation outlook."

U.S. Treasury yields fluctuated after the data was released, while stock index futures and the dollar continued to rise.

According to other core data calculated from the PCE report, the so-called "core services prices" (a category of inflation closely watched by the Federal Reserve, excluding housing and energy core service indicators) rose by 0.2% from the previous month. Prices for goods excluding food and energy unexpectedly increased by 0.4%, marking the largest increase since the beginning of 2023. Another measure of overall core inflation that Federal Reserve officials have been monitoring in recent months (excluding so-called implied and estimated prices) rose by 0.2%.

The PCE report showed that nominal income in the U.S. grew by 0.9% in January, likely due to annual cost-of-living adjustments for Social Security beneficiaries. Real disposable personal income adjusted for inflation increased by 0.6%, pushing the U.S. savings rate to its highest level since June.

Another report released on Friday showed that the U.S. goods trade deficit unexpectedly widened to a record level in January due to a surge in imports of foreign goods before the tariffs promised by Trump.

Wall Street is buzzing: Is "stagflation" getting closer?

Before the PCE data report showed a cooling in consumer spending, market pessimism about stagflation had already been rising recently, with both January CPI and PPI exceeding expectations, particularly as U.S. consumers' long-term inflation expectations even reached their highest level in nearly 30 years.

The U.S. composite PMI fell from 52.7 in January to 50.4, the lowest level in 17 months. More concerning data showed that the massive service sector activity, crucial for the U.S. economy, shrank for the first time in over two years, with the service sector PMI preliminary reading at 49.7, entering contraction territory, significantly lower than January's 52.9, unexpectedly hitting a new low since January 2023.

The latest U.S. Consumer Confidence Index released by the Conference Board fell below 80 (which typically signals an economic recession), largely due to concerns that Trump's tax policies will lead to significant price increases. However, as recently reflected in the inverted U.S. Treasury yield curve, such signals are far from certain, but these are all core logic driving the recent surge in expectations of "stagflation" in the U.S. economy.

Economists from Bank of America, including Aditya Bhave and Jeseo Park, recently pointed out in a research report that some policies in Trump's agenda that negatively impact economic growth were implemented earlier than expected, while the U.S. government's fiscal stimulus policies became milder and delayed due to the Republican advantage in the House of Representatives being less than anticipated, making the narrative of "stagflation" gradually become a focal point of financial market attention