US Strategy Weekly: Lower Inflation Ahead

US Strategy Weekly                    

Lower Inflation Ahead

We like to find “crowded trades” or extremes in sentiment regarding an investment and then find the flaws in the view. One of these crowded views is the global stance on the US dollar. According to a recent Bank of America survey, global fund managers have the most bearish outlook on the US greenback in over a decade. Analysts attribute this weakness to concerns regarding US policy predictability and Federal Reserve independence. In both cases, we feel the fear is overhyped and would not hold up to scrutiny. Nevertheless, pessimism has been correct with the dollar down over 11% since its peak in early January 2025. But we would point out that part of the dollar’s weakness is a result of the narrowing of the trade deficit since this results in less demand for dollars. Analysts may simply be using policy and the Fed as the reason for the weakness. Ironically, a weaker dollar makes US exports more attractive so in the long run a weaker currency can be good for the economy. In our opinion, a weaker dollar is not a major concern — although it can be inflationary — and the reason is simple. Modern currency is fiat money backed only by trust and confidence in a country. This trust is based upon the stability and transparency of its government and banking system, the strength of its economy, the relative level of inflation, and geopolitical and military power. In sum, the US has more of these important qualities than any other competing currency. Dollar weakness could simply be the greenback’s adjustment to the narrowing of the trade deficit.   

In terms of measuring US economic strength and relative inflation there were two important reports last week. January payrolls are always a problem — for several reasons. Each January, the establishment survey is benchmarked to new data gathered from the Quarterly Census of Employment and Wages – QCEW – which counts jobs covered by the unemployment insurance tax system. In addition, seasonal adjustments are reworked with more current data. This January the BLS also changed the birth-death model to include current sample information.

The household survey also undergoes an annual adjustment for new population data from the Census Bureau in January; however, this adjustment was delayed this month. And finally, the BLS noted that severe winter storms resulted in the household data response rate falling to 64.3%. In short, the January jobs report was riddled with issues making any worthwhile analysis impossible. Nevertheless, we did see the growth rate for total household employment fall from 1.5% YOY to 0.4% YOY. The establishment growth rate was also low at 0.2% YOY and has been relatively unchanged since October. In short, recent data releases suggest weak job growth. See page 3.

We have been writing about the weak growth in total employment which began in 2024 and continued in 2025. One risk is that AI will continue to dull job growth. If so, we worry that this could lead to a recession, particularly since a recession is best defined as a year-over-year decline in total employment. Nonetheless, the unemployment rate fell from 4.4% to 4.3% in January. The underlying data showed a significant divergence in unemployment rates among levels of education. The rate for those with less than a high school diploma fell from 5.6% to 5.2%. High school graduates saw unemployment jump from 4.0% to 4.5%. The rate for those with some college or an associate degree fell from 3.8% to 3.6%; whereas a college degree or higher saw a rate increase from 2.8% to 2.9%. These were unusual changes, but due to the various adjustments and low survey response in the January jobs report we believe the numbers are too unreliable to draw any conclusions. See page 4.   

January’s inflation numbers were better than expected with the headline CPI index falling from 2.7% YOY to 2.4% YOY and core inflation falling from 2.6% YOY to 2.5% YOY. However, many of the components of the CPI grew faster than headline, especially the index for fuels and utilities which rose 1.1% for the month and 6.1% YOY. This inflation in utilities and energy services is taking place even though energy commodities fell 6.6 % YOY in January after falling 3.0% YOY in December. This contradiction is due to supply and demand disruptions at the consumer end. The previous administration’s environmental policies resulted in the subtraction of nearly 17 gigawatts of reliable baseload power generation in the US. These 17 gigawatts are enough to power 12 to 15 million homes or the equivalent of the output of 17 large nuclear reactors. This huge decline on the supply side was coupled with soaring demand for energy from large data centers which support AI and crypto mining. These two factors are the likely causes for the differentiation between falling raw material prices and soaring energy services pricing. See page 5.

The debate regarding the inflationary impact of tariffs on consumers is answered by the chart on page 6. There was some increase in durable and nondurable consumer prices in the middle of 2025, but this never rose to more than 1.9% YOY in durables and 2.3% YOY in nondurable. In January 2026, the price indices for durables rose 0.4% YOY and nondurables rose 1.3% YOY. However, service sector inflation rose 3.2% YOY. Service inflation has been high, first driven by housing prices, then by motor vehicle insurance, followed by a spike in hospital & related services, and more recently led by household insurance pricing. These rolling spikes in pricing have kept service inflation above 3% YOY for the last four years. Nevertheless, the 3.2% YOY seen in January matches the November 2025 level, both of which were the lowest since August 2021. Note that service sector inflation is closely tied to employment costs and the employment cost index (ECI) was 3.4% in the fourth quarter, the lowest since the second quarter of 2021. AI should also help to keep employment costs low and employee productivity high in coming years. See page 6.

Core CPI indices have been steadily decelerating since the cyclical peak made in September and are now clustered in a range of 1.8% YOY to 2.4% YOY. In all cases, core indices are equal or down from January a year ago. This is good news for consumers. But a few sticking points remain, and these currently include necessities such as utility and housing insurance costs. See page 7.  

A main reason for our optimistic inflation forecast of 2.2% or less in 2026 is that crude oil prices continue to be negative on a year-over-year basis. Inflation has rarely if ever moved substantially higher when energy commodity prices are falling. However, as we noted, policy factors and demand changes have impacted energy services pricing. We expect the current administration will address both supply and demand issues this year. If so, the fed funds rate could move lower in 2026, but we would not be surprised if the FOMC required several more months of data before cutting rates. Traders are currently pricing in a 63% chance of a 25-basis-points rate cut at the June meeting, which is a recent upward shift. Note that in March 2022 the real fed funds rate was at its lowest and most dovish level in over 75 years! See page 8. This was a contributing factor to the 9.1% YOY peak in the CPI in June 2022. If the Fed delays cutting rates again in the face of a weakening job market, they risk being wrong one more time.

Technical indicators favor the bulls, particularly the NYSE cumulative advance/decline line which made a new high on February 17, 2026. However, the 10-day average of daily new lows has moved above 100, shifting this indicator from positive to neutral. The rotation of leadership and questioning of AI-related fundamentals is a positive factor for the longer run in our view; but we would not be surprised if the S&P index spends more time consolidating below the 7,000 level. We remain a buyer of weakness.

Gail Dudack

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