Top-line U.S. inflation is moving back toward levels where it is appropriate for the Federal Reserve to pause in its efforts to restore price stability.
With underlying inflation hovering around 3% and 4%, the Fed is well positioned to keep its policy rate steady this week with the confidence that top-line inflation and drivers of core pricing are likely to ease notably in the coming months.
Inflation increased by 0.1% on a monthly basis in May and was up by 4% on a year-ago basis while core inflation advanced at a 0.4% rate on the month and by 5.3% from a year ago.
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Excluding food, energy and shelter, inflation increased by 0.3% monthly in May and was up by 3.4% from a year ago. The decline in overall inflation in May was driven by a 3.6% drop in energy costs, which have now fallen by 11.7% from a year ago, and by a 5.6% decline in gasoline prices, which are down by 19.7% over the past year.
The policy-sensitive service inflation excluding housing, or the so-called super-core metric, increased by 4.6% on an annual basis.
Perhaps more encouraging is the near-term progress in the service sector. While service sector inflation, which comprises 61.5% of the index, advanced by 6.3% from a year ago, the monthly increase was 0.2% and the three-month average increase was 2.6% .
That implies that there is relief in the inflation pipeline in the area of the economy where inflation is stickiest and closely associated with wage demands.
If policymakers concerned with risk of a wage-price spiral were looking for relief, it is staring at them inside the data.
Policy implications
The inflation data supports the notion of at least a pause in the Federal Reserve’s rate hike campaign as it tries to push inflation back toward its long-term target of 2%.
Policymakers can take such a step with the confidence that the data will most likely experience a large top-line decline toward 3% in June, driven by the volatile food and energy component.
Should the cost of rents and shelter turn over in the way that the Cleveland Fed’s weighted new tenant repeat rent index implies, then perhaps the Fed can consider a longer pause that may be consistent with a policy peak as core and super-core inflation ease back toward a tolerable 2% to 3%.
While we think that Fed could always impose one to two more rate hikes because of elevated core and super-core inflation, the developments on the supply side should provide comfort to policymakers who are concerned with financial stability. Short-term rates are rising toward levels (5%) that have caused the recent turmoil among local and regional banks just as the lagged impact of past rate hikes are taking a toll on economic activity.
The data
Away from the large decline in energy and gasoline prices, inflation data is starting to look far more constructive given what will almost certainly be improvement in the cost of shelter and used vehicles.
Housing costs increased by 0.2% in May and were up by 6.8% over the past year. Over the past three months, housing costs increased by 2.3%. Shelter increased at a 0.6% pace in May while owner’s equivalent rent was up by 0.5%.
Food and beverage costs increased by 0.2% on the month and rose by 6.6% over the past year. The food and beverage index has barely budged over the past three months, offering the prospect of some disinflation going forward. That is a very good development for households.
The cost of new vehicles declined by 0.1% and the price of used vehicles advanced by 4.4%. But the Manheim Used Vehicle Value Index, which tends to lead the cost of used cars by one to two months, is declining, which implies future relief on that part of the consumer price index.
Adding further relief to overall service sector inflation was a 3% decline in airline fares and a 0.1% increase in medical care costs. Over the past three months, airfares have declined by roughly one half of one percent and medical care costs have dropped by just under 0.1%.
Apparel costs increased by 0.3% in May, recreation costs dropped by 0.1%, education and communications prices declined by 0.2% and commodities costs dropped by 0.2%.
The takeaway
Overall inflation is declining, driven by year-over-year relief through the energy and commodities channel.
Improvements in supply side pricing are another sign that inflation will continue to ease. In June, we expect the top-line estimate to fall significantly and most likely be closer to 3% than the current 4%. In addition, it is likely that by the fall we will see the top-line consumer price index dip into the 2% range.
We are also likely to observe further improvements in goods and housing-driven inflation. The data also suggests that further relief on service sector inflation, which has been sticky, will become an important part of the economic narrative later this year.
While we note that getting inflation from 9.1% to 4% will be easier than driving it down from 4% to 3% and then 3% to 2%, it is important to note that the direction and pipeline pressure inside the service sector are all moving in the right direction. And that is something to celebrate.
