Disinflation across the economy driven by easing goods and some service costs is good news for beleaguered households that have had to bear the burden of both inflation and interest rate shocks in recent years.
The 3% year-ago increase in the consumer price index reported by the Labor Department on Wednesday is down from a peak of 9.1% in June 2022 and represents a considerable policy achievement by the Federal Reserve.
But gains from here will be far more difficult. Our forecast implies that the top-line consumer price index will ease to 2.8% by the end of the year and average 2.3% next year. There is a long way to go before the central bank can take its focus off restoring price stability.
The easing in top-line inflation in June was led by the energy complex, where comparisons to the high prices of a year ago helped push energy prices down by 16.7% year over year. In addition, pricing pressures in used cars and airfares resulted in a de-acceleration in inflation to just under 3% on a year-ago basis and 0.2% in June on a monthly basis.
Core inflation excluding food and gasoline advanced by 0.2% during the month and was up by 4.8% on a year-ago basis. All of those declines illustrate a modicum of disinflation that is now working its way through both the goods and service sectors.
The closely watched super-core metric, or services excluding housing, increased by 4% on a year-ago basis, which remains elevated and supports our call for the Federal Reserve to lift rates by 25 basis points at its meeting later this month.
But the three-month average annualized pace of the supercore rate is now at 2.1% and the six-month average is at 3.1%, which implies that further easing on core services excluding housing inflation is in the pipeline.
Policy implications
Despite the improvement in the inflation data, the Fed is going to raise its policy rate by 25 basis points to a range between 5.25% and 5.5% at its next meeting.
Read more perspectives on economic headwinds facing the middle market.
But there is no such consensus over the September meeting, and that battle has begun. Given the implied easing of inflation in the pipeline, we may be in sight of an interest rate peak in the current policy cycle.
It would be a misnomer to label any aspect of restoring price stability as easy. That policy objective will get considerably more difficult as the Fed now faces both communications and policy problems.
First, the central bank must speak in clear and accessible ways to a public that is benefiting from easing inflation and rising wages on why the Fed needs to lift the policy rate and push inflation back to 2% at the cost of rising unemployment.
The best research implies that the public will tolerate an inflation rate between 3% and 4%. Now, with inflation reaching this range, expect the public, firm managers and political actors to be shouting, at increasing decibel levels, for the Fed to declare victory and stop hiking rates.
As the Fed approaches the final lap in restoring price stability, it will find the public and a political sector far more resistant in light of the costs in lost jobs of re-establishing a 2% target.
This is the sacrifice ratio, and in our view the Fed would need to send the unemployment rate to somewhere between 4.7% to 5% to achieve that 2% target. With the public benefiting from a historically tight labor market and an unemployment rate that has ranged between 3.4% and 3.7% in recent months, that will be difficult at best.
Second, core inflation, which is the best long-term predictor of overall inflation, stands at 4.8%. Given the unwillingness of the fiscal authority to use the potent tools inside its toolbox, the Fed will have to either continue to lift rates or create conditions that result in a steeper yield curve through greater quantitative tightening to slow activity in the real economy.
On point: The nonfinancial firms that comprise the overwhelming majority of firms inside the real economy care little about rates at the short end of the curve. Rather, they care about rates at the long end of the curve.
As the Fed approaches the end of its rate hike campaign, if it wants to bring inflation back down to 2%, the most efficient way to do so excluding excessive rate hikes is push rates at the long end of the curve higher by reducing its balance sheet. But that reduction would push the cost of doing business higher along with real rates as inflation eases.
Price stability is a precondition of maximum sustainable employment, and the Fed’s work is not yet complete. The Fed will soon have to choose how it defines that condition and what costs it is willing to accept to achieve its policy objective. That is why for some time we have been in the camp that the Fed will consider lifting its inflation target to 3% from the current 2% when it next evaluates its policy regime.
The data
The energy sector illustrates the powerful gravitational pull on overall inflation from one year ago, with energy commodities declining by 26.8% and gasoline by 26.5%. Given the burden of adjustment that U.S. households have had to bear because of the energy shock that followed the Russian invasion of Ukraine, this data points to real relief as inflation falls and real wages rise modestly.
The service sector overall had a 0.3% increase in prices on the month and was up by 5.7% over the past year. Services excluding energy increased by 0.3% on the month and were up by 6.2% year over year. On a three-month average annualized pace, service sector inflation is easing toward 2.7%, which should provide a real sense of relief for the Federal Reserve.
The policy-sensitive housing sector slowed to a 0.3% increase in June and a 6.3% advance over the past year. Shelter costs and the owner’s equivalent rent series increased by 0.4% on the month and by 7.8% on a year-ago basis. Overall housing costs are now increasing at a 2.5% three-month average annualized pace.
Apparel costs increased by 0.3% on the month and were up by 3.1% from a year ago. Airline fares declined by 8.1% on the month and by 18.9% on the year. Medical costs did not increase in June and were up by 0.1% over the year. Recreation costs increased by 0.1% on the month, education and communications costs declined by 0.2%, while commodity costs excluding food and energy dropped by 0.1%.
Food and beverage costs increased by 0.1% in June and were up by 5.7% from a year ago.
The takeaway
Inflation is easing and that is good news indeed. Goods prices and prices across the service sector are easing and point to top-line inflation averaging 3% in the current quarter and 2.8% in the final quarter. Our forecast implies that the consumer price index will average 2.3% next year. With considerable progress on inflation now obtained, the more difficult final leg of that journey is at hand. That will require at least one more rate hike and most likely an acceleration in drawing down the Fed’s balance sheet to push longer rates higher.
