Lower CPI, higher change for a pause on FED

US CPI cooling supports Fed inaction tomorrow.

Source: Haver Analytics

In May, the United States experienced a slowdown in price pressures, primarily due to a decrease in gasoline prices. As a result, the CPI only advanced by 0.1% on a month-to-month basis, which was in line with expectations. When excluding food and energy, the core CPI increased by 0.4%, also meeting expectations. This rise was driven by higher shelter prices and a significant increase in used car prices. Of particular interest was the Federal Reserve's preferred price measurement, which focuses on prices linked to underlying demand. In May, core services, excluding rent of shelter, saw a 0.2% increase, resulting in a three-month annualized pace of 3.0%. This figure represented a decline from the 4.2% pace recorded in the previous month. Considering these developments, it is expected that policymakers will maintain their current stance during tomorrow's interest rate announcement. However, there is a possibility that officials might lay the groundwork for future interest rate hikes in the third quarter, given the labour market's resilience.

In the Federal Reserve's favoured gauge of core services excluding rent of primary residences and owners' equivalent rent, transportation services saw an increase, while other categories like recreation services, medical services, and education and communication services declined. The decline in certain discretionary service sectors suggests that past rate hikes may have successfully curbed demand, providing some reassurance to the Fed.

For the second consecutive month, there was a substantial 0.6% surge in core goods prices, primarily driven by a significant increase in used car prices. However, except for medical goods, which experienced price decreases, most other core goods categories saw more moderate price rises. While car dealers continue to have limited inventories, retailers outside the automotive sector have inventory-to-sales ratios that match pre-pandemic levels. This is expected to prevent significant price increases in core goods, excluding automobiles, soon. As interest rate hikes take effect and progress is made in improving the supply chain, the demand for automobiles is likely to diminish, which will help to curb prices. Continued efforts to enhance the supply chain will also contribute to price containment.

The shelter component of the index picked up pace, rising by 0.6% and reversing the previous downward trend observed earlier this year. Notably, hotel prices experienced a significant surge of 2.1% after a notable decline in April. Meanwhile, the rate of rent increases for primary residences slightly slowed to 0.5%, and owners' equivalent rent-maintained a pace of 0.5%. I anticipate that the lingering impact of last year's lower rental prices will gradually influence the indices, playing a crucial role in bringing the core CPI index back to 2.0% by 2024.

Analyzing the overall CPI, I observe a significant 5.6% decrease in gasoline prices, contributing to downward pressure on electricity and natural gas prices as well. Despite this, grocery store prices saw a modest 0.1% increase, which overshadowed a notable 13.8% decline in egg prices. It is worth noting that this drop in egg prices is the second largest monthly decrease ever recorded, reflecting an improvement in the avian flu situation. Consequently, consumers would have had more available funds for spending in other areas, with restaurant prices exhibiting a robust 0.5% increase.

The yearly inflation rate for the overall CPI experienced a significant decline, dropping from 4.9% to 4.0%. This reduction was partly influenced by base effects and marks the slowest pace recorded since May 2021. Similarly, core annual inflation also decreased slightly, by two basis points, reaching 5.3%.

Economic forecast — Today's inflation data showed tame advances in enough key categories to justify a pause from the Fed tomorrow. Although the annual core inflation pace will continue to cool in the summer months, helped by base effects, the ongoing strength in the labour market suggests that 2.0% inflation won't be attainable on a sustained basis, and we could see two final 25bp rate hikes in Q3 from the Fed as a result.

Markets — Bond yields fell, and the greenback depreciated ahead of the release, with both remaining around those levels following the data release, as this report wasn't seen as strong enough to bring a Fed hike as early as tomorrow.

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