Financial markets were hit this week with negative news on both consumer and producer price inflation. Tuesday’s CPI report showed inflation running at 3.8% on a 12-month basis, well above the Federal Reserve’s 2% inflation target. Even more concerning, the data showed inflation accelerating again after a period of moderation. Then, on Wednesday, the Treasury market was rattled by a much larger-than-expected increase in producer price inflation. For April, PPI rose 1.4%, far above the market expectation of a 0.5% increase.
The central question for financial markets is whether the current spike in inflation is transitory or whether the United States faces a renewed inflation problem that will require the Federal Reserve to raise interest rates.
The issue confronting the Federal Reserve is critically important. With contained inflation, households can make informed decisions about purchasing durable assets such as homes and cars. They do not have to worry that the value of their savings and investments will be eroded by persistently rising prices. Businesses also benefit from stable inflation because it encourages long-term capital investment. Strong investment drives sustained productivity growth, which is the foundation of rising living standards for all Americans.
For now, the Federal Reserve is reacting correctly to the recent inflation readings. Inflation, which had been trending lower, has accelerated again because of the surge in oil and gasoline prices caused by the Iran war and the temporary disruption to shipping through the Strait of Hormuz. Understandably, there are growing calls for the Federal Reserve to respond aggressively by raising interest rates. That would be a mistake. The Federal Reserve should continue to adopt a wait-and-see approach.
The current inflation surge is primarily the result of a geopolitical supply shock, not an overheated domestic economy driven by excessive consumer demand. Personal consumption growth, which drives the economy, is running at under 2%, hardly an inflationary pace. Monetary policy is also a blunt instrument. Higher interest rates cannot produce more oil, reopen shipping lanes in the Persian Gulf, or lower gasoline prices in the short term.
The U.S. economy has already endured multiple supply shocks over the last several years. Now the Iran war has created another energy shock. In this environment, the Federal Reserve must be careful not to overreact to temporary inflation pressures that are likely to ease over time.
A cautious response is especially warranted because there are no signs of a wage price spiral. Wage growth remains subdued, with hourly earnings increasing at roughly 3.5%. At the same time, the U.S. economy is experiencing a productivity renaissance, with productivity growth running above 2%. Low wage inflation combined with strong productivity growth means businesses are not facing severe margin pressure that would force them to raise prices aggressively. Corporate profit margins remain healthy. Moreover, alternative inflation measures such as the Dallas Federal Reserve’s trimmed mean index, which excludes outliers, show core inflation running at a more moderate 2.4%.
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Historically, central banks often make their biggest mistakes when they panic during commodity price spikes. Raising interest rates aggressively in response to an energy shock can weaken economic growth without meaningfully reducing inflation. Higher borrowing costs would slow housing activity, business investment, and hiring.
The Federal Reserve should not short-circuit what appears to be sustainable 2% economic growth accompanied by rising productivity. It should stay calm and wait for more data.
James Rogan is a former U.S. foreign service officer who later worked in law and finance for over 30 years. Now he writes a daily note on markets, economics, politics, and social issues.