INFLATION: Not what the headlines said
If you read the paper today, you probably got the wrong impression about what the latest CPI data said about where inflation is heading. Here's what you need to know.
Markets really want rate cuts. Politicians really want rate cuts. Businesses really want rate cuts. Everyone who builds homes, or wants to buy a home, really wants rate cuts. If you read the newspaper this morning, you likely saw a flurry of headlines stating that the latest CPI data brings us closer to, that’s right, rate cuts. Those headlines, to put it nicely, missed the mark.
There are good data-driven arguments for a September cut. And there’s no question that the July employment report, with its huge downward revision to job gains this summer, is a sign that the labor market is even weaker than we all thought. But this morning’s CPI release was an argument against rate cuts, not for them.
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Monthly inflation is heating up before Labor Day. Let’s start with the facts. The monthly inflation rate for core CPI was 0.322% in July. Is that hot? Ab-so-lut-ley. The monthly rate associated with 2% inflation over 12 months is 0.165%. July was nearly double that. another way of thinking about that is if inflation ran at the same rate for 12 months that it did in July, the yearly inflationary rate would be 3.6%. Is that 1980s chaos inflation? Nope. But it is both well above the Fed’s target - core CPI of 3.6% implies that core PCE would be above 3.0% - and it’s moving in the wrong direction. As the figure below shows, it’s not just the CPI data. The pace of monthly core PCE data has been rising since May.
Tariffs weren’t the only reason inflation popped. There were signs that tariffs are having an impact. Prices for used cars rose at a decent clip, as did prices for apparel and household furnishings. But it wasn’t all tariffs. Prices of medical care services were hot, and inflation in the transportation sector hit 1.0% m/m. The volatile category of airline fare jumped 4.0%. Overall, services less energy inflation rose by 0.4% (that’s up from 0.3% in June and 0.2% in May. Shelter inflation is down from its post-pandemic heater, but it’s still rising at a healthy clip, and that’s with the most unaffordable housing market in generations. I’m not sure what everyone else was looking at, energy prices did decline *golf clap*, but this was fairly widespread, which will be hard to argue are “one-time tariff” shocks.
Forecasts for July core PCE are probably too low. For much of recent history, the monthly change in core CPI has nearly uniformly outpaced the monthly change in core PCE. Things changed a bit after the pandemic. Core PCE started to outrun core CPI more often. This year, that dynamic has been even more pronounced. Four of the six months for which we have both core CPI and core PCE data had the monthly change in PCE > CPI. Things can always reverse, and some of the hot categories in the CPI release, like airfares and medical care services, are calculated differently in PCE, but the latest CPI data points to a hot core PCE (the Fed’s preferred measure) at the end of August.
I know, we’re a broken drum, but yearly inflation is about to stall out. We’ve been talking about this for a while: the 12-month change in core PCE inflation, the Fed’s preferred measure of inflation, is about to stall out in the second half of the year. The reason is something wonky called base effects - the reference point for the 12-month change is messing with the numbers. Given the current state of the labor market, policymakers might have been willing to overlook this as inflation relief is coming early next year, were it not for those hot monthly readings. There’s a real risk that inflation stalls out above 3.0%, above last year’s stall out. If we stack a couple of hot monthly readings together (and let’s not forget all of this data is for the period before the August round of tariffs) and inflation could hit 3.25% by the end of the year. Again, that’s not end of the world stuff. But it is significantly hotter than last year and will make key hawkish members of the FOMC pause.
No, the labor market data didn’t change much. There was a collective freakout after the downward revisions to job gains in May and June. Some of that is fair. It was one of the largest combined revisions on record. It emphasized just how shaky conditions in the labor market are at the moment. But that is not new information. Sure, they’re even more fragile than we thought, but they’re not dire. Recessions are accompanied by large job losses. Even if you can’t see them in real-time, as we pointed out in a March labor market post, real-time employment data during the onset of the 2001 recession was volatile and unclear, slower job growth is not a recession. The economy still added 73k jobs in July. Yes, a lot were in healthcare and social assistance; this year, that sector has accounted for almost 79% of all job gains, but it’s not yet a crisis.
The Fed isn’t going to spike the ball just yet. The labor market is fragile, and it may still fall off a cliff, but it’s going to take that for key policymakers to walk away from their commitment to 2% inflation after they missed the boat in 2021 and 2022. Powell keeps saying it: the best thing they can do for a stable economy is bring inflation back to 2%. When someone tells you who they are, believe them.
There will be some dissents, but the Fed is going to make sure either the labor market is a dire place, or inflation is sustainably back down to 2.0%, before they start the end zone celebration.
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