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Inflation cools but not enough

The chairman has become skittish about raising rates.

The consumer price index (CPI) rose 0.1% in May, after soaring 0.4% in April. That translated to a deceleration in inflation to 4.0% on a year-over-year basis from 4.9% last month. A surge in inflation following Russia’s invasion of Ukraine in February 2022, helped dampen the year-over-year comparisons. Those “base effects” start working in reverse over the summer, as inflation peaked in June 2022. Prices at the gas pump alone plummeted 5.6 during the month; they were down nearly 20% from a year ago.

The core (excluding food and energy) CPI rose at a 0.4% pace in May, the same as we saw in April. Core CPI cooled to a 5.3% gain from a year ago, slightly below the 5.5% pace of April. Again, base effects played a role but not as much in overall inflation figures. Shelter costs continued to rise at 0.6% in May, with an acceleration in homeowners’ equivalent rent offsetting a slight deceleration in apartment rents. The Fed will be watching the recent bottoming of home values closely. Bottoming home values were one of the items the Bank of Canada surprised markets with the resumption of rate hikes at its May meeting.

Housing-related goods continued to cool, with month-to-month declines in furniture and appliance prices. Apparel held up better, with people still filling their suitcases for travel.

Used vehicle prices accelerated at a stunning 4.4% pace for the second consecutive month, after becoming a drag on growth earlier in the year. Used vehicle prices picked up between January and March and have since lost that momentum. It takes two to three months for whole vehicle and changes in their prices to show up on dealer lots. Rental vehicle fees continued to moderate after soaring in 2021 and early 2022.

Core services, which strip out shelter costs, rose at a 0.4% pace in May, a slight acceleration from the pace of April. Core services rose 4.2% from a year ago. The core services component of inflation, which makes up more than half of the PCE measure of prices, has been stuck in the 4.2% to 5% range for six months.

Medical and airfares are measured very differently in the CPI versus the PPI or the PCE, which the Fed targets. Medical costs and airfares contracted slightly on a month-to-month basis but are expected to rise in the PPI and PCE measures for the month. That should buoy the core services component of the PCE index, which has raised red flags at the Federal Reserve, as evidence inflation is becoming more entrenched.

Revenge travel remained strong, with consumers opting to venture more abroad this year. Those who were unable to work due to vacation hit another monthly record in May; it was the strongest May since 2005, while TSA throughput over the Memorial Day weekend exceeded 2019 levels. Lodging away from home rebounded by a whopping 1.8% on a month-to-month basis; costs at restaurants remained extremely elevated.

Insurance costs continued their upward march. Climate change is playing a role in buoying those costs, as a surge in extreme weather events is boosting damages. A move to light trucks and heavier electric vehicles is another issue; they are buoying the cost of damages when vehicles collide and the cost of repairs. Labor shortages have also bid up the costs of maintenance and repairs.

Fed Chairman Jay Powell has become more skittish about raising rates further than many of his colleagues. He would like to skip the June meeting with the option to revisit a hike in July. He is watching financial stability and wants to assess the credit tightening in the pipeline before going further on rate hikes. This report will not change that decision; he is incredibly good at corralling the cats. If the data remains as stubborn as it looks like it is likely to do for the core services measure of PCE, the Fed will move again to raise rates in July. 

Inflation is cooling due to a moderation in both food and energy prices.

Bottom Line:

Inflation is cooling due to a moderation in both food and energy prices; that is welcome news. The slowdown in year-over-year measures of inflation is being exaggerated by peak inflation figures in May and June of 2022 and could firm again later this year. Those shifts and the persistence of core inflation have given the Fed leeway to pause but not bring its rate hiking cycle to an end. We expect that most on the Fed will show that they expect to raise rates another half percent in 2023 when they release their updated forecasts for the June meeting. 

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Meet our team

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Diane C. Swonk
Chief Economist, KPMG US

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