Inflation Moderates in May

The Consumer Price Index (CPI) rose a tepid 0.1% in May, a deceleration from April. Year-over-year gains in the CPI also decelerated a bit in May to a 1.8% pace, largely in response to a drop in prices at the gas pump. Food prices rose in May after softening a bit the month prior. The largest gains showed up in nonalcoholic beverages but were also significant in meat, poultry and eggs. Restaurants are feeling the pinch and passing those price increases onto consumers.

The core CPI (excluding food and energy) rose 0.1% in May and 2% from a year ago, off slightly from the read we saw last month. One big shift in the report was the apparel price index, which flatlined instead of declining. A measurement change in March - one major retailer shifted to providing its actual data instead of allowing government surveyors into the stores - caused a major drop in apparel prices in March and April, but that is beginning to play out. This is one of the reasons that the Federal Reserve has previously argued that the slowdown we have seen in inflation was transitory. That said, CPI tends to run hotter than the Fed’s preferred inflation measure, the Personal Consumption Expenditures (PCE) index; both are still too cool for the Fed’s liking.

The key going forward is what happens to shelter costs. Lodging away from home is softening a bit, while a surge in mortgage refinancing and a slowdown in housing appreciation could place a drag on those figures. This contrasts with the expectation by some that delays in home buying will keep upward pressure on rents, especially for millennials. My bet is that shelter costs decelerate and keep the lid on inflation more than the Fed would like.

Monthly and weekly earnings both got a boost in response to slower inflation. This is critical for consumers as nominal wage gains appear to be decelerating again, another trend the Fed would like to circumvent.

Today’s inflation data will have to be taken into account when the Federal Open Market Committee (FOMC) meets next week. Markets are widely and accurately expecting the Fed to cut rates preemptively in July. My preference is for a June rate cut, because the Fed will release new forecast data after its June meeting. Fed Chairman Jay Powell would have more latitude to seize control of the Fed’s narrative if it moves a little before the market expects, in June, instead of July. That said, Powell may still be corralling cats among the Fed’s regional bank presidents.

Bottom Line
Inflation is cooling when it should be warming. This, coupled with concerns that the trade war with China will intensify, will prompt the Federal Reserve to cut short-term interest rates preemptively this summer. Our forecast includes a second cut in rates by year-end as the tolls associated with weaker global growth and tariffs intensify.

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