By Kathleen Brooks, research director at XTB.com

US inflation data was a touch stronger than expected for February, rising by 3.2% on an annual basis for the headline rate, the core rate fell to 3.8% from 3.9% in January, but that was still higher than the 3.7% expected. On a monthly basis, core inflation rose by 0.4%, which is a fairly hot reading and is the same level as January’s increase. This complicates the picture for US interest rates and makes next week’s Fed meeting even more important for the future direction of financial markets.

Service price growth remains as stubborn as ever

The details of the February inflation report suggests that service prices show no signs of abating. On a monthly basis, core service inflation was 0.34%, this is lower than the 0.5% increase in core inflation for January, but it remains strong.

The biggest contributors to inflation for February was the price of gasoline and the shelter index. Combined, these two indices contributed more than 60% to the increase in last month’s inflation increase. Shelter continues to be a thorn in the side for central bankers, and it continues to defy expectations that it should decline on the back of higher interest rates. The shelter index rose 0.4% last month. However, even if you strip out the shelter index, then the super core inflation rate is still too high for the Federal Reserve. The super core rate rose by 0.47% on the month, down from 0.85% in January, which is encouraging, however, the deceleration in service price inflation remains slow.

What comes next for the Fed?

Overall, this is not the evidence that is likely to lead to a more dovish Federal Reserve next week. Instead, the Fed Chair Jerome Powell is likely to maintain his message that the Fed will need more time to see how inflation evolves before they cut rates.

Is this a seasonal blip?

It is worth noting that historically, inflation tends to rise in the first few months of the year, as this is when businesses and companies can increase their prices. Thus, the Fed should not overreact to the stronger inflation prints for January and February.

From a market perspective, today’s data should not have a material effect on financial markets. US stocks have whipsawed since the release; however, markets have been able to rally since the hotter than expected January inflation print, and we don’t think that the February number will knock the rally in stocks in the short term. Added to this, at the time of writing, the initial upswing in US Treasury yields has faded, and 2-year Treasury yields are at the lows of the day around 4.52%.

Caution abounds

Overall, we expect financial markets to trade with a cautious tone in the coming days leading up to next week’s Fed meeting. As mentioned, this higher-than-expected inflation print, complicates the picture for the Fed. The question now is, will the Fed tolerate two months of higher-than-expected inflation, or will they talk tough on price stability next week? 

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