US inflation: great progress, but risks remain
Headline inflation is now a fraction of its peak level; however, by itself, shelter’s contribution is greater than the FOMC’s 2.0%yr target.
In June, both the headline and core CPI outcomes were below expectations at 0.2%, leaving the respective annual rates at 3.0%yr and 4.8%yr, materially below their 2022 peaks of 9.1%yr and 6.6%yr. The so called ‘Supercore’ measure (core services ex housing) was midway between the headline and core prints at 4.0%yr and compares to a peak in 2022 of 6.5%yr.
In the underlying detail is clear evidence of a broad-based deceleration in price pressures. On a six-month annualised basis, inflation for ‘food at home’ has slowed from 12.5% last July to 2.5%; while ‘food away from home’ has eased from 10.8% in October to 6.3%. Inflation for goods ex energy and food is also only a fraction of its 2021 peak rate, 2.6% compared to 13.9%. Though in recent months, there has been considerable variability in price outcomes by item.
Whereas apparel has experienced consistent monthly gains of 0.3% over the past four months and new vehicle prices are little changed, used car prices rose 4.4% in both April and May and then only declined 0.5% in June. Conversely for services, while medical care and education prices are marginally lower over the past four months and recreation costs modestly higher, airline fares have plunged, -2.6%; -3.0%; and -8.1% in April to June to be 18.9% lower than a year ago. Clearly the post-pandemic re-opening has run its course; but, as for used cars, some sectors still face an imbalance between demand and supply.
The most important area of the economy facing such a concern is housing. While the shelter component of the CPI, which is primarily determined by rents, has decelerated from an average reading of 0.7% through Q1 to 0.5% in Q2, that still equates to a 6% annualised pace for Q2, twice the average pace back to 1994. Given its 35% headline CPI weight, shelter is currently contributing 2.1ppts to inflation on an annualised basis. For core, the contribution is larger still at 2.6ppts as shelter’s weight within the core is 43.5%.
This is a critical point to highlight: shelter has the capacity to create at or above target outcomes for inflation by itself if current rates of rent inflation persist. Our baseline expectation is instead that it will follow the market rent measures down through the remainder of the year to a still above average 4.5% annualised pace at December, allowing headline inflation to ease to 2.0% annualised. But clearly there are risks to the upside.
Changing tack, the Federal Reserve’s July Beige Book was also released overnight and was constructive for the outlook. Economic activity was reported to have “increased slightly since May”, employment only “modestly”. Most significant for inflation is that the “unusually high [labour market] turnover rates in recent years appear to be returning to pre-pandemic norms” and contacts “in multiple Districts reported that wage increases were returning to or nearing pre-pandemic levels”.
While not a factor for shelter, these outcomes support the case for a continued deceleration in discretionary service categories of inflation such as ‘food away from home’ and travel, particularly as momentum in goods input costs has already receded. The “reluctance to raise prices because consumers had grown more sensitive” shown by contacts in some districts in May to July is therefore likely to gain greater traction ahead, further helping to moderate inflation outside of housing. Price pressures seen as “generally stable or lower over the next several months” support this thesis.
With respect to the implications for the FOMC, as above we anticipate that by year end, six-month annualised inflation will be at 2.0%yr, albeit with the risk of a higher pulse if the shelter component shows greater persistence. On an annual basis, that equates to a 2.6%yr annual rate against the FOMC’s 3.2%yr expectation as per their June forecasts. At year-end, we also expect to see the unemployment rate around 4.0%, in line with the FOMC’s current expectation, and annual GDP growth of 0.7%yr, below the FOMC’s 1.0%yr forecast. Note, part of the difference between our and the FOMC’s expectation for growth through 2023 is a contraction in Q4 2023, which we see as the first part of a small technical recession over the six months to March 2024.
We therefore see the FOMC progressively becoming more focused on the risks to activity through the second half of 2023, having completed the tightening cycle in July with a 25bp hike to 5.375% and highlighted the need for policy to remain contractionary for an extended period at August’s Jackson Hole Symposium. The most likely timing for the first cut is therefore March 2024 when we expect a 25bp reduction (note, previously we had forecast 50bps of cuts in Q1 2024, but the January meeting now seems too early and 50bps at March too sudden). Rate cuts are then expected to continue at 50bps per quarter through Q2 2024 to Q2 2025, leaving the fed funds rate at 2.625% mid-2025 (unchanged from our prior forecast). At that level, the fed funds rate is best considered broadly neutral, being in line with the FOMC’s 2.50% ‘longer run’ expectation. As is the case in late-2023, the prime risk for 2024 and 2025 is that shelter inflation is stronger than currently forecast, leaving little room for inflation elsewhere in the consumer basket.
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