July U.S. CPI Offers Some Relief, But Fed Also Watches Other Inflation Indicators

As expected, U.S. inflation – both headline and core – moderated in July, according to the latest Consumer Price Index (CPI) data. Assuming global food and energy commodity prices continue to ease, June likely marked the peak in the year-over-year (y/y) rate of headline inflation. However, the y/y rate of core inflation will likely reaccelerate in August, and may not peak until September.

The categories that drove the July weakness in core – airfares and hotels – tend to be more volatile, whereas the stickier components – rents and owners’ equivalent rents (OER) – remained firm in July.

The CPI report, and the recent moderation in short-term inflation expectations, are surely a relief for Fed officials, but with inflation still expected to moderate to a pace that is above their 2% long-run PCE (personal consumption expenditures) target, the July CPI isn’t likely to change the near-term trajectory for monetary policy. Indeed, restrictive policy still appears appropriate, meaning more rate hikes are still to come.

Prices drop for energy, hotels, airfares, used cars

The July report showed U.S. core CPI increased 0.3% month-over-month (m/m) – softer than consensus expectations of 0.5% m/m. The moderation was almost entirely due to price drops across hotels, airfares, and used cars. Indeed, airfares fell −7.8% m/m as lower jet fuel prices passed through to consumers. Hotel prices, after surging well beyond pandemic levels earlier this year, appear to be normalizing (they fell −3.3% m/m) as the initial surge in reopening demand fades and consumers struggle with high prices. We expect airfares will remain weak, but hotel prices could post small gains in coming months.

New car prices continued to climb (+0.6% m/m) as inventories remain near record lows and production data indicate disruption continued through the spring and early summer. Meanwhile, used car prices fell −0.4% m/m and are likely to drop again next month before reaccelerating somewhat in the fall. Rental car companies aren’t expected to sell into the used car market as aggressively as usual in the coming months due to the continued dearth of new cars. Nevertheless, over time we expect used car prices to retrace some of their exponential price gains since the pandemic, as higher interest rates, slower migration out of city centers, and a normalization in new vehicle inventories moderates demand for used vehicles.

Prices in most retail goods categories continued to rise in July despite Amazon’s Prime Day promotions, which, in the past, tended to induce discounting across retailers. Although prices for apparel and various electronics finally appear to be seeing some discounting, continued strength in household furnishings, recreation goods, and other products suggests that surging inventories and declining real goods spending has not yet translated to broad-based price discounting.

Turning to core services, rents and OER were once again firm, and we expect the y/y rate of rents and OER will continue to accelerate, possibly reaching as high as 8% – well above the 3.5% pre-pandemic trend. Counterintuitively, interest rate hikes tend to boost rental inflation at first, because they make owning a home less affordable. Typically it’s not until housing price inflation starts to more materially moderate that rental inflation also starts to fall (reported CPI inflation tends to lag broader housing market trends by 3–6 quarters).

The most notable area of disinflation came (unsurprisingly) from energy prices, which fell −4.5% m/m. However, food inflation remains stubbornly strong despite weaker commodity prices. Food prices jumped 1.1% m/m, accelerating slightly since June. Overall U.S. headline inflation fell from 9.1% y/y in June to 8.5% y/y in July, and assuming commodity prices continue to ease, the peak headline inflation is likely behind us.

What the Fed sees in CPI and other inflation data

Short-term inflation expectations have been moderating along with food and energy prices. However, despite the July report, we still believe Fed officials will be concerned about several underlying trends in inflation. The year-over-year rates of core inflation measures (e.g., Cleveland Fed trimmed mean, New York Fed underlying inflation gauge, Atlanta Fed sticky price measure), which historically have tended to be better predictors of future inflation, have all accelerated in recent months, given the increasing depth and breadth of inflationary pressures across items in the consumer price basket.

More concerning to the Fed, U.S. wage inflation has broadened from the low-wage, low-skill services sectors to a range of industries, occupations, and skill levels. The Atlanta Fed wage tracker has increased rapidly – behavior that resembles a non-linear Phillips curve, and/or accelerating inflation expectations. Furthermore, this has happened despite a productivity recession, implying unit labor costs have substantially increased – something corporations will likely aim to offset by increasing prices to maintain margins.

The outlook for inflation to moderate to a still above-target pace should keep the Fed on track to position monetary policy to restrict the economy. That means more outsize adjustments to the policy rate are still likely appropriate in an effort to ensure that U.S. inflation is well-anchored at target.

Please visit our Inflation and Interest Rates page for further insights on these key themes for investors.

Tiffany Wilding and Allison Boxer are economists and regular contributors to the PIMCO Blog.