Another Strong Month for Inflation

The Consumer Price Index rose 0.1% in June and 2.9% from last year, its fastest pace since early 2012. Gains were largest in housing, transportation, gasoline, and hospital services. The upswing in hospital services reverses a trend of deceleration earlier in the cycle. The elderly are particularly hard hit by these shifts in health care costs, which are expected to remain a push instead of a drag on inflation in the near term.

Core CPI, which excludes the volatile energy and food sectors, rose by 0.2% relative to last month and 2.3% on a year-over-year basis. Year-over-year growth increased for both the overall and core indices relative to last month. This suggests that the Federal Reserve’s preferred measure of inflation, the PCE deflator, will cross the Fed’s target once it is released late this month. The PCE more fully captures changes in service sector prices, which were one of the primary drivers of the larger-than-expected increase in pipeline inflation in the June Producer Price Index (PPI).

The rise in transportation costs is also notable as it is being driven by escalating freight changes. While consumers have come to expect free shipping over the past few years, these deals are becoming less common.

Today’s data marks the fourth consecutive month in which core CPI was above the 2% mark and affirms the Fed’s commitment to four rate hikes - two additional are predicted this year. Tariffs could further complicate the Fed’s decision making as they will show up in inflation before they show up as a slowdown in growth. Given this, this year’s relatively hawkish FOMC voters, and what looks to be a blowout second quarter driven by a federal spending surge, the risk is rising that the Fed may want to open the option for an additional rate hike. The two things holding them back at the moment are: 1) still-tepid wage acceleration and 2) concerns that a flattening yield curve may be signaling a recession. There is no consensus on this in the Fed.

Chair Powell has committed to symmetry in the inflation target - running inflation above its 2% target for a period of time to allow for a catch-up in wage gains. However, he has been deliberately vague about what that actually means when it comes to a decision rule for policy.

Separately, the administration has already begun to criticize potential Fed rate hikes. Powell will likely become a political piñata for both the administration and Congress as the Fed continues its rate hike path. The disdain for the Fed is bipartisan. The irony is that Republicans who once criticized the Fed for keeping rates near zero are now arguing for fewer rate hikes.

Bottom Line
The economy is surging and inflation is finally reflecting those gains. Wages are still lagging. This - coupled with the escalating trade war - will put the Fed between a rock and a hard place when it comes to rate hike decisions. They need to counter inflation by law but the tariffs will also weaken growth, which could tip the economy into an earlier-than-expected recession.

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