Inflation was slowing before tariffs, but the good news might not last. What's next?

The Personal Consumption Expenditures (PCE) index is expected to show a minimal increase of 0.1% in April, potentially lowering the 12-month inflation rate to 2.2%, nearing pre-pandemic levels; however, the inflationary effects of higher U.S. tariffs are beginning to surface, and a recent study suggests inflation expectations have become "unanchored," raising concerns that inflation may not return to the Fed's 2% target and could reignite, similar to the 1970s.

Analysis

The U.S. Personal Consumption Expenditures (PCE) index is anticipated to show a modest 0.1% increase for April, mirroring March's flat reading, which could bring the 12-month inflation rate down to 2.2%, approaching pre-pandemic levels and the Federal Reserve's 2% target. While the core PCE, a preferred measure for underlying trends as it excludes food and energy, is also projected to rise by a slight 0.1%, its 12-month rate would remain somewhat elevated at 2.6%. Despite this near-term moderation from the 7.3% PCE peak observed in 2022, significant headwinds persist that challenge the narrative of a sustained return to low inflation. The inflationary impact of U.S. tariffs is only now beginning to materialize, with economists forecasting a potential resurgence of inflation towards 3%, even considering some previous tariff relaxations. Compounding these concerns, a new study by Coibion and Gorodnichenko, gaining traction in economic circles, suggests inflation expectations have become "unanchored," indicating public skepticism about the Fed's ability to maintain low inflation, drawing parallels to the persistent inflationary environment of the 1970s and early 1980s. The authors explicitly warn that "any significant spark could reignite the fire," and suggest that rising import prices may already be fueling this risk, implying the battle against inflation is far from decisively won.

Key Decisions for Investors

• Investors should closely monitor upcoming PCE data releases but interpret them cautiously, weighing the near-term figures against the emerging and potentially more dominant risks from tariffs and shifting inflation expectations.
• It is prudent to assess portfolio allocations for resilience in a scenario where inflation proves more persistent or re-accelerates, which could prompt a more hawkish Federal Reserve stance and increase market volatility.
• Developments in U.S. trade policy, specifically concerning tariffs and their pass-through to consumer prices, as well as ongoing legal challenges to tariff impositions, warrant careful observation as key potential drivers of future inflation dynamics.