The Big Idea
Ominous inflation news
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Inflation optimists were riding high when the January CPI failed to show the outsized increase in core inflation that many, including me, expected. But a couple of developments since then offer reason for concern. First, according to the PPI, wholesale and retail margins are expanding substantially after absorbing tariff costs and narrowing for much of 2025. On top of that, the surge in the ISM Manufacturing Prices index, which measures input cost hikes, suggests inflation pressures continue to make their way through the pipeline and will continue to plague wholesalers and retailers going forward. These results suggest the Fed is far from victory in its battle to bring inflation back to 2%.
Margin requirement
One of the biggest surprises last year stemming from tariff-related volatility was that companies proved very patient and judicious in seeking to pass through their added costs. My first conception back around the time of Liberation Day was that firms would take a couple of months to digest the impact of the tariffs imposed in April and then would adjust prices relatively quickly, so that the inflation impetus from tariffs would be over by the end of the summer. In retrospect, that was a grossly incorrect conjecture.
I suspect that this patience reflected two factors. First, the tariff policy itself proved highly uncertain. Tariffs were raised and lowered, imposed and reversed, in multiple cycles, leaving a great deal of questions about the ultimate landing point. A number of firms expressed to Fed officials and others last year that they preferred to hold off on price hikes in the near term, absorbing the costs for a time, to avoid being forced to raise prices multiple times as the situation evolved. In addition, many companies, especially those that face consumers, were concerned about the degree of antipathy that their customers have at the moment to higher prices and were afraid of antagonizing their client base—or in the case of a handful of especially large retailers, may have felt pressure from the administration to avoid hiking prices.
In any case, firms generally exercised considerable discretion in their price setting. This can be seen in a pair of PPI categories. Since the PPI was revamped years ago to expand its scope, the two largest line items by weight are wholesale trade services and retail trade services. I have long objected to the inclusion of these categories in the PPI. They have nothing to do with wholesale prices. Instead, these two line items measure the margins of wholesalers and retailers. While that may not tell us anything about the evolution of producer prices, the data do at times yield valuable insights.
This is one of those times. The PPI trade services series track the narrative laid out above well. Wholesale trade services “prices” declined on balance by well over 1% from April through October. Similarly, retail trade services “prices” slid by 2.5% from June through November. This is hard evidence that both wholesalers and retailers were absorbing costs and watching their margins shrink.
Of course, it is unlikely that a business can survive over time while seeing its margin continually shrink. It has been my contention and numerous others’ that companies would eventually need to pass their higher costs through. A natural time for firms to revisit their pricing strategy has always been the turn of the year. Indeed, even before the tariff price pressures arose, more generalized inflation has often been concentrated early in the year. The core CPI rose by 0.4% or more for four straight Januarys from 2022 through 2025. This was why the reasonably benign 0.3% advance in the January CPI was viewed as such a good outcome.
However, the PPI trade services results suggest that, despite the January CPI result, businesses are in fact making a belated effort to restore their margins. The wholesale trade services gauge has risen in three straight months by a cumulative 4.9% from November through January, including a chunky 2.4% jump in January. Similarly, the retail trade services measure moved up in December and January by a combined 3.4%, including a 2.0% surge in January.
These results suggest that wholesalers and retailers have begun to make a concerted effort to pass through more of their cost increases, suggesting that the January CPI reading may have been more of a brief respite than a final declaration of victory. This flies in the face of Governor Waller’s take on February 23: “There were many anecdotal reports that firms had been holding the line on prices through 2025 but planned markups in January as contracts were renewed at the start of the year. But we didn’t see as large a jump in prices as some expected in the CPI data and it’s hard to believe that February is ‘the new January’ when it comes to resetting contract prices. So that story doesn’t seem to be holding water.” The PPI data suggest that this may prove to be a premature “mission accomplished” declaration.
But wait, there’s more
It would be bad enough for the Fed’s prospects of achieving 2% inflation any time soon if businesses are going to play catch up in the coming months, pushing through last year’s input cost hikes. However, in the end, that is something that the Fed could ultimately look through, as it should be, by definition, a temporary force.
The trouble is that there is evidence that input costs continue to escalate, even as the level of tariffs has mostly stabilized. The February ISM Manufacturing Survey measure of prices, a gauge of input cost changes, surged by more than 11 points to 70.5, the highest reading since 2022. Firms specifically cited tariffs generally and also a rise in steel and aluminum costs, which is also due mainly to tariffs on those commodities. This underscores the cascading impact of tariffs. In addition to retailers being forced to pay tariffs on the finished goods that they import, tariffs on basic inputs like metals will continue to push the cost of production higher over time, even for domestic manufacturers whose final output is not subject to tariffs. It is understandable that it may take considerable time for the full impact of tariff hikes to filter down to consumer prices.
For what it’s worth, the ISM Non-Manufacturing Survey price gauge for February was not quite as threatening as its manufacturing counterpart. In fact, it actually declined in February to 63.0. The good news is that this was the lowest reading since before Liberation Day. The bad news is that it was still well above 60, indicative of fairly widespread input cost increases, even outside of the manufacturing sector, which has borne the heaviest impact from tariffs. In fact, the ISM Non-Manufacturing Survey price gauge has been above 60 for 15 straight months and has been in the high 50s or above all but one month since March 2020. For reference, a reading of 50 indicates that the number of firms reporting increases and decreases are equal. Price pressures obviously pre-date tariffs, but the ISM gauges suggest that firms not only are playing catch-up from past input cost increases. They also are continuing to see their input costs rise, suggesting that the passthrough dynamic could persist for a while.
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