Inflation Still Sticky

MACRO FRAME

Fourth-quarter growth slowed to 1.4%, reflecting softer government outlays and exports, though underlying private demand remained firm at 2.4%. Inflation pressures continue to moderate on a quarterly basis, with core PCE easing to 2.7% annualized in Q4. However, December’s 0.4% monthly core PCE print highlights that price pressures remain sticky on a near-term basis, reinforcing the case for a patient Federal Reserve.

STOCK INDEX FUTURES

Equity indexes are lower following an upside surprise in the Fed’s preferred PCE inflation data, while fourth-quarter GDP figures came in below expectations. Real GDP increased at an annualized 1.4% in Q4, a sharp deceleration from Q3’s 4.4% pace. The slowdown primarily reflected declines in government spending and exports, alongside softer consumer spending. The federal government shutdown subtracted roughly 1 percentage point from Q4 growth. Despite the headline slowdown, real final sales to private domestic purchasers rose 2.4%, indicating that underlying private demand remained intact.

Headline PCE rose 0.4% month-over-month in December, while core PCE also increased 0.4%, both figures above forecasts for a rise of 0.3%. On a yearly basis, PCE inflation rose 2.9%, a step above the previous 2.8%, while core prices rose from 2.8% to 3.0%.

Watch point: Growth cooled materially, but much of the drag was tied to government and trade dynamics. Private sector demand remains steady, while inflation continues to ease gradually on a quarterly basis.

CURRENCY FUTURES

US DOLLAR: The USD Index reversed earlier losses following this morning’s data, which supports the stance of an extended pause from the Fed. The combination of resilient domestic demand and persistent services inflation keeps the rate differential backdrop modestly dollar-supportive. With markets still pricing easing later in the year rather than imminently, DXY is likely to remain rangebound but biased to the upside on any upside inflation surprises. Near term, dollar direction will continue to track front-end yield expectations and incoming inflation data, particularly any signs that monthly core pressures are reaccelerating or, conversely, resuming their cooling trend.

Watch point: Following a hawkish receipt of January’s Fed meeting, Friday’s PCE data reinforced policy timing expectations of  summer easing offers short-term underlying support for the dollar.

EURO: The euro maintained weakness against the dollar following US data to trade near $1.1764. Flash PMI data showed business activity across Germany, France, and the broader eurozone continued to expand, though services activity came in slightly below expectations. The HCOB Flash Eurozone Composite PMI, compiled by S&P Global, rose to 51.9 in February from 51.3 in January, marking a 14th consecutive month of expansion.

Manufacturing provided the upside surprise, with the headline PMI climbing to 50.8 from 49.5 as the new orders index moved back into expansionary territory at 50.9. While early, the rebound suggests a potential stabilization, and possibly a turnaround, in the manufacturing sector.

Services activity edged higher to 51.8 from 51.6. Overall, price pressures ticked up. Firms raised output charges at a more measured pace, offering little reason to materially alter expectations that the European Central Bank will maintain a steady policy stance in the near term.

ECB President Christine Lagarde told the Wall Street Journal on Thursday she expected to complete her eight-year term at the head of the central bank, following a report earlier in the week she was planning to step down. Despite near-term softness, the euro continues to draw structural support from capital flows and relative equity performance.

Watch point: Sustained appreciation above $1.20 would materially raise expectations of verbal or policy intervention from ECB officials, though action from the bank is unlikely.

BRITISH POUND: The Sterling is higher against the dollar but gave up earlier gains following US PCE data to trade near $1.3472. Investors modestly increased rate-cut expectations despite strong January retail sales and firm February PMI data signaling that labor data earlier in the week outweighed Friday’s data. Retail sales rose 1.8% month-over-month, the fastest pace since May 2024, marking the first back-to-back increase in six months, with gains driven largely by non-food store demand as easing inflation and prior rate cuts supported consumption. Labor data earlier in the week pointed to gradually softening conditions, with the unemployment rate rising to 5.2% in Q4, its highest level outside the pandemic since 2015, while wage growth continued to cool.

Flash PMI data also pointed to improving activity, with the UK S&P Global Composite PMI rising to 53.9 from 53.7, above expectations. Manufacturing output strengthened notably (53.6 vs. 51.6), while services activity remained elevated (53.9 vs. 54.0). New orders increased at the fastest pace since September 2024, suggesting improving sales pipelines despite a still-fragile macro backdrop. However, employment continued to decline as firms cited rising labor costs, and output price inflation accelerated to a ten-month high, reflecting higher wage and commodity expenses.

Markets currently price roughly a 80% probability of a 25 bps cut at the March meeting, up from 76% before the data and roughly 50 bps of easing by year-end.

Watch point: A March rate cut is increasingly in consideration given disinflationary trends, though still-firm services inflation could present a hurdle to further easing.

JAPANESE YEN: The yen weakened against the dollar to 155.36 after strong PCE data and as domestic inflation figures showed price pressures eased to their lowest level since March 2022. Annual inflation slowed to 1.5% in January from 2.1% in December, as food inflation declined to a 15-month low, driven in part by a moderation in rice prices. The outcome was broadly in line with Bank of Japan projections that inflation would temporarily dip below its 2% target.

Money markets continue to price a potential rate hike by June, with the January inflation report having only a muted impact on expectations. However, a sustained slowdown in food-price growth could push back the timing of further policy normalization if broader price momentum weakens.

Separately, Prime Minister Takaichi reiterated her commitment to avoiding “reckless fiscal policies that undermine market confidence,” though FX markets showed little immediate reaction to the remarks.

Watch point: Improving sentiment toward Japan’s growth outlook should lend near-term support to the yen, though concerns over expanded fiscal spending may act as a headwind to further appreciation.

AUSTRALIAN DOLLAR: The Aussie is weaker, but held above $0.70 as new data showed February flash PMIs softened across the board, signaling slower growth momentum but still-elevated inflation pressures. Composite, services, and manufacturing readings all eased from January, though each remained above the 50 threshold, indicating continued expansion.

Labor data earlier in the week showed the unemployment rate held at 4.1%, below expectations for a rise to 4.2%, while employment increased by 17,800. The firm labor backdrop follows Q4 wage growth of 3.4% year-over-year, reinforcing signs that domestic cost pressures remain present.

Money markets currently price roughly a 76% probability of a 25 bps rate hike in May, while June and August are favorable to a hike. The combination of resilient labor conditions and still-elevated price pressures keeps the Reserve Bank of Australia biased toward further tightening despite signs of moderating activity.

Watch point: Evidence of sustained moderation in core inflation or a clearer slowdown in household demand would likely temper tightening expectations, while continued strength in price and spending data could keep policy bias firm.

INTEREST RATE MARKET FUTURES

Treasury yields reversed earlier losses to trade slightly higher across the curve, following this morning’s data. Fourth-quarter GDP slowed to 1.4% from 4.4% in Q3, reflecting weaker government spending and exports, with the federal shutdown alone subtracting roughly one percentage point from growth. While the headline deceleration appears material, underlying private sector momentum remains firmer than the top-line suggests. Real final sales to private domestic purchasers rose 2.4%, signaling that consumer and business demand has not rolled over.

From an inflation perspective, the quarterly data showed continued, though gradual, moderation. Core PCE within the GDP report eased to 2.7% annualized, down from 2.9% in Q3. However, December’s monthly PCE release complicates the disinflation narrative.

In December, core PCE rose 0.4% during the month, with the year-over-year rate holding at 3.0%. Services spending drove the gain, while goods spending softened. The 0.4% monthly core print annualizes to a pace well above the Fed’s 2% objective, suggesting that services inflation, particularly in labor-sensitive categories remains sticky.

This backdrop supports a patient Fed stance, limiting the urgency for near-term easing while keeping mid-year cuts in play should disinflation resume. The data mix is consistent with continued front-end sensitivity to inflation surprises, while longer maturities remain anchored by moderating growth expectations.

Market-priced odds remain favorable to a cut July, with markets pricing 56 bps of total easing by year-end. The 10-year yield is unchanged at 4.075%.

Watch point: With labor data pointing to continued stability and inflation remaining sticky, even as the year-over-year pace eased slightly, a summer rate cut remains the base case rather than an imminent move.

The spread between the two- and 10-year yields is 59.70 bps, while the two-year yield, which reflects short-term interest rate expectations, is 3.476%.

 

 

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