The bottom line? Near-term spike in inflation not a foregone conclusion
- The better-than-expected reading on May consumer inflation should elicit a collective sigh of relief for investors, consumers, and policymakers.
- For all the understandable concern about the potential for meaningful price hikes on a range of imported goods, the combination of implementation delays and tangible progress in negotiations with major trade partners is alleviating concern around the feared worst-case scenario becoming a near-term reality.
- That doesn’t mean that consumers are happy. Lower inflation doesn’t mean lower prices. Many consumers are still trying to adjust to the sharp increase in prices in recent years. It’s that reality that remains a major headwind to consumer confidence and has curtailed discretionary spending.
- The good news is that there’s now a more plausible path to steady or even lower inflation in the coming months than seemed possible two months ago.
- If the most notable tariffs can be pushed off long enough for trade negotiations to yield positive results, the greatest impact of the April tariff announcements may yet turn out to be negotiating leverage rather than resurgent inflation. That’s far from a guarantee but appears to be a greater possibility today than many believed in the immediate aftermath of the so-called Liberation Day announcement.
By the numbers: May consumer inflation tamer than expected
- The consumer price index (CPI) rose by a very tepid 0.1% in May, below already manageable expectations for a 0.2% month-over-month increase. Over the past three months, CPI has risen by just 0.2% — far from what one might expect given the degree of angst over tariffs and the resulting impact on prices for a wide range of imported goods.
- Core CPI, which excludes food and energy, also rose by 0.1%, a positive surprise compared to forecasts for 0.3% for the month.
- On a year-over-year basis, headline CPI increased by 2.4%, while Core CPI rose by 2.8%, with falling energy prices accounting for most of the difference.
Broad thoughts
- On a backward-looking basis, both headline and core inflation came in higher than Fed policymakers would prefer, given the central bank’s price stability mandate. Even so, broad-based inflation pressures still appear to be gradually easing, with tariffs being the notable wild card around the near-term outlook. That’s carrying through to market-based gauges of inflation expectations, which have also shown recent signs of moderating.
- The fact that recent readings on consumer inflation have been softer than expected and tame by virtually any measure isn’t what one might expect, considering the overwhelming economic narrative of the last few months has focused on tariffs and near-term expectations for higher prices.
- Goods inflation was virtually nonexistent in May, albeit with some notable exceptions. Major appliance (+4.3%) and toy (+2.2%) prices surged in May as a direct result of import levies. Even so, weaker-than-expected service sector inflation may be the more noteworthy development.
- Once the disruption of the COVID-19 pandemic dissipated, (i.e. supply chain disruptions and social-distancing induced goods buying binge), the service sector emerged as a primary driver of the surge in the consumer price index. Most notably, a combination of soaring shelter costs and surging wages were the primary catalysts.
- More recently, labor conditions have softened as hiring demand has slowed, while higher home prices and elevated mortgage interest rates have significantly curtailed homebuyer demand.
- For headline inflation to recede back to 2%, service sector inflation needs to cool. In that regard, May’s CPI report offers tangible evidence of progress.
- Tomorrow’s producer price index (PPI) report will provide additional clarity around the broader inflation picture. A cooler PPI would lend further credence to the case that near-term inflation concerns, however reasonable they were, may have been overdone. Conversely, a hotter PPI report could suggest that businesses are absorbing higher input costs rather than passing them on to their customers, which would weigh on margins.
- Alternatively, higher producer prices could present an early warning to consumers of higher prices still in the pipeline. In that case, May’s tepid CPI report could be the anomaly, with a resurgence in upward pressure on consumer prices coalescing in the coming months.
- Boil it all down, and the May CPI report should provide some reason for optimism, but with the acknowledgment that the twists and turns of policy developments may still hold some surprises.
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