The inflation indicator most favored by the Federal Reserve is cooling down, but under the heavy pressure of tariffs, the market is hotly debating about "inflation stagnation."

The Federal Reserve's preferred inflation measure - the so-called "core personal consumption expenditures price index" (core PCE) - showed a moderate increase in January, providing some relief to concerns about a return of inflation after a series of economic data reports showed US price pressures heating up again, while consumer spending cuts and a decrease in consumer confidence could potentially lead to a downturn in the US economy. However, the PCE report showed a larger-than-expected drop in consumer spending, which could raise concerns about the resilience of the US economy. With recent economic data showing strong inflation pressures, weak consumer spending, significant cooling of business activities, and exceptionally low consumer confidence, the market is beginning to discuss the possibility of the US economy entering a period of "stagflation." Expectations for a Fed rate cut have not changed significantly after the PCE data release, with rate futures markets still betting on 1-2 rate cuts this year. However, due to pessimistic expectations due to tariffs, the market has increased its bet on the first rate cut in 2025 from September to June. Data released on Friday showed that the core personal consumption expenditures price index (excluding food and energy items), or core PCE index, rose 0.3% month-on-month in January, in line with economists' expectations, but slightly higher than December's 0.2% increase, indicating a slight uptick in the month-on-month benchmark. The PCE data report released by the US Bureau of Economic Analysis on Friday also showed that the core PCE index rose 2.6% year-on-year compared to the same period last year, in line with market expectations, marking the smallest annual increase since early 2021. The year-on-year increase in core PCE in December was revised from 2.8% to 2.9%, indicating a slight cooling in the year-on-year benchmark for the US core PCE index. On the flip side, the unfavorable news for the US economy was the unexpected 0.5% month-on-month drop in consumer spending after adjusting for inflation, the largest monthly decline in nearly four years, compared to economists' expectations of either no growth or a slight 0.1% decline. With the extreme cold weather in the US intensifying in late December and January, following the unexpectedly strong holiday shopping season, US consumer spending seems to be becoming more cautious. The latest PCE data report shows that the unexpected decline in consumer spending was caused by a drop in car purchases and purchases of durable goods, and as data shows a slowdown in service spending, this could further fuel concerns about the resilience of the US economy, given that consumer spending accounts for as much as 80%-90% of US GDP. Other data in the PCE report showed that overall PCE, including energy and food, rose 2.5% year-on-year, consistent with economist expectations, with the previous value at 2.6%, indicating a slight decline overall; while overall PCE rose 0.3% month-on-month, consistent with market expectations and previous values. Looking ahead, the progress of the Fed in combating inflation, continued price pressures, and radical policy changes including new tariffs on imported goods will determine to what extent consumers will feel the pressure. However, the data released on Friday has already shown that a significant decline in the enthusiasm of consumer spending, with previously released economic data showing weak business activities, low consumer confidence, and soft jobless claims. Additionally, the University of Michigan's latest inflation expectations for February showed that US consumers expect a 3.5% increase in inflation in the 5-10 year period, the largest month-on-month increase since May 2021 and a new high since 1995. US consumers are increasingly worried that Trump's tariff hikes will lead to price increases, and may even fear that businesses will lay off workers significantly due to inflation and high interest rates imposed by the Fed, leading them to expect significant cuts in consumer spending, which has been a strong driver of the US economy since the Fed's aggressive rate hikes in 2022. In addition, with Trump officially announcing that the US government will impose a 25% tariff on Mexican and Canadian goods starting next Tuesday, and an additional 10% tariff on Chinese imports, market concerns about a new round of global trade war are intensifying. More and more economists and Wall Street strategists are starting to discuss the possibility of the US economy soon falling into the most difficult economic dilemma for the Fed - stagflation. While core PCE shows a cooling of inflation in the US, all other economic data are suggesting a return of inflation. Despite this, the PCE data report on Friday provided a respite for the Fed in combating inflation. Previously released price reports on other items have not only shown a lack of progress in the Fed's fight against inflation, but also a reversal in the upward trend, causing concerns that the inflation beast may return with a vengeance. The previously released CPI for January increased by 0.5% month-on-month, the largest increase since August 2023. The overall US CPI in January showed a 3% year-on-year increase, the largest increase since June 2024, and January's CPI was significantly higher than economists' expectations, both month-on-month and year-on-year. The so-called "producer price index" (PPI), which measures final demand, rose 0.4% month-on-month in January, and December's PPI inflation was revised upwards to a 0.5% monthly increase after adjustments, with PPI rising 3.5% year-on-year compared to the same period last year, exceeding the market's general expectation of 3.2%. Fed officials have been emphasizing recently that they need to see a clear relief in inflation before considering restarting the rate-cutting process, especially considering the uncertainty of how Trump's return to the White House will affect prices with tariffs and domestic tax cuts. "I believe monetary policy can be patient in assessing the future path, meaning that the federal funds rate may remain unchanged for a period of time," said Cleveland Federal Reserve Bank President Betsy Hamack on Thursday. She expects the Fed's policy rate to remain unchanged temporarily while the market is looking for evidence that inflation pressures are falling back to the 2% target. Hamack also said that she will seek more evidence to prove that pricing pressures are receding before supporting rate cuts, as long as the US labor market remains healthy. It fell to 2%. She warned, "Although there are good reasons to expect inflation to gradually fall to 2% in the medium term, this is far from certain, and there is a high risk of upward inflation prospects."After the release of the data, the yield on US Treasury bonds fluctuated, while stock index futures and the US dollar remained on the rise. Other core data calculated based on the PCE data report show that the so-called "core services prices" (an inflation category closely monitored by the Federal Reserve, excluding housing and energy) rose by 0.2% compared to the previous month. Excluding food and energy, commodity prices unexpectedly rose by 0.4%, marking the largest increase since early 2023. Another indicator that Federal Reserve officials have been watching as a measure of overall core inflation (excluding prices that require estimation) rose by 0.2%. The PCE report shows that nominal income in the US increased by 0.9% in January, possibly due to annual cost-of-living adjustments for social security beneficiaries. Disposable personal income, adjusted for inflation, increased by 0.6%, pushing the US savings rate to its highest level since June. Another data released on Friday showed that due to a surge in imports of foreign goods before the tariffs promised by Trump, the US trade deficit in goods unexpectedly widened to a record level in January. Wall Street debates: "Stagflation" getting closer to us? Before the PCE data report showed a cooling in consumer spending, market sentiment towards stagflation has already been heating up recently. January CPI and PPI both exceeded expectations, especially the long-term inflation expectations of American consumers that have risen to the highest level in nearly 30 years. The US Composite PMI dropped from 52.7 in January to 50.4, hitting a new low in 17 months. More pessimistic data shows that the crucially important vast service sector activities in the US have shrunk for the first time in over two years, with a preliminary service PMI of 49.7, entering a contraction territory and significantly lower than January's 52.9, unexpectedly hitting a new low since January 2023. The latest release of the US Consumer Confidence Index by the Conference Board fell below 80 (usually indicating an economic recession), largely due to concerns that Trump's tax policies will lead to a significant increase in prices. However, as shown by the recent inversion of the US bond yield curve, such signals are far from inevitable, but these are the core logic behind the recent surge in expectations of "stagflation" in the US economy. Economists from Bank of America, Aditya Bhave, Jeseo Park, and others recently pointed out in a research report that due to some negative impact policies on economic growth in the Trump policy agenda being implemented earlier than expected, and with the US government's fiscal stimulus policy being milder and delayed due to the Republicans not gaining as many seats in the House as expected, the "stagflation" narrative is gradually becoming the focus of the financial market.