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US CPI Review: May 2023 (with bonus flash June estimates & Fed implications analysis)
Disinflation continues at pace, but the Fed's focus on lagging core inflation means that it's repeating its prior mistakes in reverse.
As expected, the US CPI recorded major disinflation in May.
On an annual basis, the CPI saw its growth rate fall to just 4.0%, down from 4.9% in April. This exceeded my expectation for a decline to 4.2%. Once lagging shelter is taken out of the equation, annual growth fell to just 2.1%. This was down from 3.4% in April, and again exceeded my forecast for a decline to 2.3%.
As expected, core inflation, which is a much more lagging indicator of inflation, did not see as significant of a decline, but nevertheless continued to move in the right direction.
Core CPI growth fell to 5.3% in May, down from 5.5% in April (vs my 5.4% forecast). Core CPI ex-lagging shelter saw a more material decline, falling from 3.7% in April, to 3.4% in May (vs my 3.5% forecast).
Breaking down inflation by its key categories, part of the reason for inflation coming in softer than my expectations, was slower than expected growth in durables prices.
This was seen in used car prices, which saw MoM growth of 3.2%, which was below the 3.5% implied by a two month lag of the Manheim Index.
Importantly, the large inflationary impulse from used car prices should now be in the rearview mirror — at least for the next two months.
A two month lag of the Manheim Index implies MoM CPI used car and truck price growth of just 0.1% in June, and a decline of 1.7% in July.
The other big driver of lower than expected monthly durables price growth came from other durables (i.e. durables excluding new and used cars), where for the second consecutive month, prices declined at a rate that was well above the historical average monthly change (across 2010-19) — note that the historical average annual growth rate across this reference period is negative 2.2%.
Overall, this meant that durables prices remained YoY negative (-0.05%) vs my forecast for growth of 0.1%.
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As expected, CPI food at home prices continued to decelerate, with annual growth falling to 5.8% (vs my 5.7% estimate). I continue to expect that annual growth will moderate over the course of 2023.
After monthly price growth moderated in April, CPI food away from home prices modestly reaccelerated in May.
The reacceleration aligned with the thinking that I outlined in my CPI preview:
“In the meantime, given that one month of significant price deceleration in April doesn’t make a trend, for May, I am conservatively forecasting a rebound in MoM growth to a level that would again be materially above its historical average.”
While growth reaccelerated somewhat, it remained below the growth rates that were seen in Q1.
Furthermore, with YoY growth falling from 8.6% in April to 8.3% in May, and many months of high prior year comparables to come, it appears that annual CPI food away from home price growth is likely to decline over the months ahead.
Turning to CPI energy commodities, the annual price decline came in above 20% as expected. With a MoM increase of 9.3% rolling out of the YoY calculation next month, I currently expect the annual decline to exceed 25% in June.
Turning to shelter costs, rent of primary residence (RPR) saw a decline in its monthly growth rate, which was right in-line with my forecast. While owners’ equivalent rent (OER) did see an increase in its MoM growth rate, it was only modest (2bps).
Given that 1) the lagging OER and RPR metrics have largely bridged the gap that had opened up to spot market rents, and 2) spot market rents are seeing a continued moderation in annual growth (as per the Apartment List Rent Index), I continue to expect that both RPR and OER will record an ongoing deceleration in their monthly growth rates — albeit a gradual one.
More broadly, while some services showed a continued persistence of high monthly price growth, there were also several positive signs of spreading disinflation in services prices.
For the first time since August 2022, CPI education & communication services prices saw monthly growth that was below its historical average. It was also the first time since July 2022 that monthly price growth was negative.
This came amidst widespread disinflation within its subcomponents: tuition fees, postage & delivery services, and telephone services all saw MoM growth that was below their respective historical averages. Meanwhile, internet services prices saw MoM growth that was only modestly above its historical average — this comes after growth in April was well below its historical average, and marks a continued shift away from the relatively high growth rates that internet services prices generally saw across October 2022-March 2023.
In contrast to the positive signs that have been seen in education & communication services prices, the transportation services category continued to see some components record high monthly growth rates.
While MoM growth was again lower than the high levels that were generally recorded across June 2022-January 2023, there was a noticeable uptick in CPI motor vehicle maintenance prices in May, versus their historical average.
Though as is the case with CPI food away from home prices, the cycling of high prior comparables over the months ahead, is likely to lead to a material moderation in its annual growth rate — which was equal to a very high 13.5% in May.
Motor vehicle insurance prices continued to surge higher in May, rising 1.7% MoM. This was the largest upward deviation from its historical monthly average that has been seen in the current high inflation cycle — clearly, motor vehicle insurance prices are not showing any signs of disinflation.
Though showing much more positive signs, were recreation services prices, which FELL in May. This marked the first monthly decline in prices that has been seen since August 2022. In comparison to the historical monthly average, this was the largest move to the downside since November 2021.
With MoM growth also materially below its historical average in March, June’s data will carry outsized importance as to whether a picture of more moderate price growth is beginning to emerge.
After recording record MoM growth in April, other personal services price growth moderated significantly in May. Interestingly, just like recreation services, two of the last three months have seen somewhat more modest growth (although to a much lesser extent for other personal services than recreation services).
Is April the outlier here, and will a new trend of more moderate price growth emerge, or will the data continue to be lumpy, with some months recording very high growth, and others seeing somewhat more modest growth?
Again, June’s data will prove important in helping to gain a better picture into what’s taking shape. While growth definitely continues to be well above its historical average, right now, there’s no clear trend as to whether monthly price growth is accelerating or decelerating.
Moving to energy services, with natural gas prices recording huge declines, to now be down 73.6% YoY on a monthly average basis, this has been flowing through to CPI utility gas prices — the historical correlation suggests that further downside lies ahead.
Flash June CPI estimates — NOTE provisional & subject to change
As part of my commitment to continually improving the service that Economics Uncovered provides, starting from this edition of my monthly CPI Reviews, I intend to provide a flash (i.e. provisional) estimate of the upcoming CPI report.
While subject to ongoing review (with my final monthly estimate to be published in the upcoming CPI Preview), my flash estimate for the headline CPI is for another major decline, with annual growth falling to 3.0% in June. On an ex-lagging shelter basis, I currently expect inflation to fall to just 0.7% in June.
In terms of the core CPI, I currently expect annual growth to see a more material decline in June, falling to 4.9%, from 5.3% in May. For core CPI ex-lagging shelter, I expect growth to fall to 2.8%, from 3.4% in May.
The Fed’s focus on core inflation is a huge concern — it significantly raises the odds of a deflationary bust
While the Fed’s latest FOMC meeting resulted in no interest rate hike for the first time since February 2022, the Fed also released an updated set of economic projections, in which the median estimate for the year end federal funds rate was increased from 5.1%, to 5.6%. This implies two more interest rate hikes by the end of the year.
In justifying this hawkish outlook in his press conference, Fed Chair Powell continued to keep coming back to one thing — core inflation.
Given that the Fed believes that core inflation provides a better indicator of where overall inflation is headed, it’s easy to understand why the Fed continues to remain concerned about inflation — core inflation remains stubbornly high, which at 5.3%, is only a modest decline from January’s 5.6%.
Though here’s the problem. The Fed’s wrong. Core inflation doesn’t provide a better indicator of where overall inflation is headed. Instead, it provides a LAGGED indication of broad price changes.
Firstly, the exclusion of food and energy prices means that the 2nd phase of the price cycle, being nondurables prices, is largely ignored.
Secondly, by excluding nondurables prices, the core CPI has a greater weighting to lagging services prices.
This is why the CPI has seen significant disinflation, but the core CPI has remained relatively much more elevated.
Given its lagging nature, the Fed’s focus on core inflation creates a big problem, as it promotes delayed policy action — both when inflation is rising, and when it is falling.
As a result, the Fed is now repeating its previous policy mistakes in reverse — just as it previously dismissed rising inflation as transitory supply-chain problems, it is again dismissing the importance of falling durables prices (which are a leading indicator of overall CPI inflation), and is focusing on the most lagging component, being services prices.
This greatly increases the level of cumulative overtightening that the Fed is likely to employ. With the M2 money supply already seeing its largest declines since the Great Depression, this greatly increases the odds of a future deflationary bust.
Though even with a lagging focus, more rate hikes are going to be harder to justify after June’s expected CPI decline
Despite the Fed’s focus on the most lagging of price indicators, it appears as if it’s going to get increasingly difficult for the Fed to justify further rate hikes.
Should the CPI fall to 3% in June (as indicated by my flash CPI estimate), many politicians and business leaders, as well as the broader public, are likely to become increasingly skeptical of not only the need to increase rates to 525-550bps (let alone to 550-575bps), but of the need to maintain them at current levels of 500-525bps, as opposed to delivering rate cuts.
Questions are likely to be amplified should CPI ex-shelter come in BELOW 1% YoY in June, as I currently forecast. This is important, as THIS, as opposed to the core CPI, is a far better measure of current underlying inflation. The reason for this, is that we already KNOW that underlying spot market rents have fallen significantly, with the Apartment List Rent Index recording annual growth of just 0.9% in May, versus the lagging shelter component of the CPI, which remains at 8.0% YoY.
Should my current flash forecast for core CPI growth of 4.9%, and core CPI ex-shelter growth of 2.8% largely materialise, then the questions are likely to only grow louder and louder, for even on the Fed’s preferred measures of current underlying inflation, real rates will be positive — including VERY significant real rates for the core CPI ex-shelter.
Ultimately, June’s CPI report is likely to make it much more difficult for the Fed to justify additional rate hikes. This is important, as a higher hurdle for additional rate hikes is exactly what’s needed.
For when one is steering a big ship, it’s necessary to make required adjustments well in advance — leave it too late, and it won’t be possible to correct course before the ship runs ashore.
In terms of the world’s national economies, there’s no bigger ship than that of the United States.
Unfortunately, as opposed to making the required adjustments well in advance, the Fed took far too long to realise that action was needed to address inflation. Now, the Fed is late in recognising the need to back off, so as to avoid unnecessarily causing a major deflationary bust down the line.
While recent major bank failures provided a warning sign, it appears as if that won’t be enough to prompt the Fed to change course.
Given the Fed’s current mentality, it appears more and more likely to direct the ship in one direction — Hard Landing Cove.
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