A gradual cooling in inflation in May because of a 3.6% decline in gasoline prices, a 1.1% drop in transportation costs and 0.5% easing in the cost of new vehicles shows that the rise in inflation at the start of the year was more noise than signal.
Overall, the consumer price index increased by 3.3% on an annual basis while core inflation excluding food and energy advanced by 3.4% from a year ago and by 0.2% on the month. Inflation excluding food, energy and shelter was flat and increased by 1.9% from a year ago.
Read more of RSM’s insights into the economy and the middle market.
A gradual disinflation is reasserting itself and will continue throughout the summer. This should play into the Federal Reserve’s forecast, which points to a September rate cut as both the consumer price index and the personal consumption expenditures index inch back toward the Fed’s long-term 2% inflation target.
While base-year effects, or comparisons to the strong pace of disinflation a year ago, will slow the decline, a restrictive policy rate and consumer fatigue over elevated prices will most likely push firms to slow price increases or in some cases cut them. This reluctance to raise prices has been the case for consumer products firms that primarily serve lower-income households.
Since the price shock of 2021 and 2022, we have made the case that the Fed will find it difficult to get inflation back to 2% and remain there. This is one of the major reasons why we think the terminal federal funds rate will end up at 3% or higher.
A much-needed policy discussion on the appropriate level of the central bank’s inflation target will be necessary once the Fed achieves its 2% target next year.
The data
We are starting to observe the long-awaited easing in housing costs. Housing costs on a three-month average pace rose by 3% in May. That rate is in contrast with the 4.6% year-ago increase and 0.3% monthly increase in May.
Shelter increased by 0.4% on the month, and rose by 5.4% annually and by 4.8% on a three-month average pace. The policy-sensitive owners’ equivalent rent increased by 0.4% on the month and by 5.7% on a year-over-year basis. But over the past three months, owners’ equivalent rent was up by a more moderate 4.8%.
This easing should provide relief to policymakers who have been waiting for housing prices—which have materially eased in other real-time data—to decline more quickly.
Just as important, service costs, which advanced by 0.2% in May and were up by 5.2% on the year, have eased to a 3.7% pace over the past three months.
Food prices increased by 0.1% and were up by 2.1% from a year ago. On a three-month basis, food was up less than 1%, which should provide some much-needed relief to beleaguered lower-income consumers.
The big decline in overall transportation costs was fueled by a 3.6% drop in airline fares, which offset a 0.5% increase in medical care and a 0.6% rise in used auto costs.
Recreation costs declined by 0.2%, education and communications costs were flat on the month and commodity prices dropped by 0.4%.
The takeaway
The encouraging May CPI data released by the Labor Department on Thursday is likely to be the first in a string of constructive inflation reports that will define policy normalization at the Fed and set the table for the rest of the business cycle.
Gasoline prices peaked in March, and a rising supply of global crude should provide a much-needed assist in the disinflation process in both domestic and international economies.
As we have argued for some time, the key factor in the Fed’s getting back to its 2% target is the degree to which the imputed cost of housing and owners’ equivalent rent eases in the second half of this year.
