A chill in goods prices helps cool inflation

June 28, 2024

Personal disposable incomes jumped 0.5% after adjusting for inflation in May, up from 0.3% in April but well in line with March. Personal consumption expenditures (PCE) increased by 0.3% in May, after rising a tepid 0.1% in April. Gains were broader based than earlier in the year, with increases in both goods and services, although services dominated.

The saving rate moved up to 3.9%, the highest since January, suggesting that consumers are entering the summer with some room to run on spending. July spending is likely to be helped by a month’s forbearance on student loans for those enrolled in the new SAVE plan; the plan is designed to lower monthly payments.  The excess savings that we saw during the month are showing up in deposit accounts, where it is now earning much higher interest than it did in the 2010s.

The PCE index, the Fed’s favored measure of inflation, moved sideways in May, with a drop in goods prices adding to the disinflation in prices in the service sector. Food prices edged only 0.1% higher, while energy costs dropped by 2.1% in May. That translates to an increase of 2.6% from a year ago, a slight improvement from the 2.7% increase we saw in April.

The drop in goods prices reflects stockpiling and early ordering ahead of new tariffs and anticipated supply chain disruptions later in the summer. Everything from geopolitical tensions, a record storm season and the threat of strikes at US ports has prompted producers to order early. The move was so dramatic that some stores started selling Halloween décor online prior to the Fourth of July holiday. That is insane.

The 2.6% annual rate is the lowest since February, when inflation appeared to accelerate on a seasonally adjusted basis. The year-on-year measures of inflation become more difficult in the second half of the year due to the extraordinary improvement we saw in the back half of last year.

The core PCE rose by 0.1% in May, a sharp deceleration from 0.3% in April. That is the lowest monthly reading on inflation since November 2020 and translates to an increase of 2.6% from a year ago, down from 2.8% in April and the lowest annual reading since March 2021. The primary drag on core inflation was a drop in goods prices, which fell 0.2% excluding energy. That was the largest drop in goods prices since December 2023, when an easing of supply chain problems helped reduce goods inflation.

Shelter costs remained elevated during the month. However, the CPI survey for shelter costs was distorted by an overweighting in a high-cost market; New York City alone added 0.1% to owner’s equivalent rents, due to poor survey response rates. That should abate as we get into the second half, which will help the shelter costs to finally roll over and become more of a drag on inflation in the second half.

The super core PCE services, which make up half of the core measures and is most closely watched by the Fed for inflation triggered by wage gains, rose 0.1% in May. That is its weakest pace since August 2023. That translates to a 3.4% increase from a year ago, down from 3.5%. The year-over-year measures for super core services are the most difficult to bring down in the back half of the year due to base effects.

The three-month annualized pace for core services fell to 3.3% in May from 3.6% in April; the six-month annualized pace was essentially unchanged. coming in at 4.1% in May from 4.2% in April. The service sector is where inflation has proven stickiest and remains an area that the Fed needs to see cool more dramatically before cutting rates.

The largest sticking point for service sector inflation in May was in healthcare costs, which surged 0.7% during the month. That is the fastest pace of healthcare costs since January 2021, when people started to catch up on health care appointments that lapsed during quarantines. The main driver of healthcare costs was an increase in hospital costs, up 1.3% during the month, the fastest pace since August 1983. Aging demographics and shortages of healthcare personnel and the legacy of COVID, which left more people sick and hospitalized than prior to the pandemic, are the reasons for that increase.  It will be tough for the Fed to eliminate them with rate hikes.

Insurance costs for vehicles, home and healthcare accelerated 0.4% during the month, the fastest since January 2024. The acceleration in insurance, which moved in the opposite direction of the CPI and PPI reports for the month, was a surprise and suggests upward revisions to the PPI data. Vehicle insurance, which cooled in the CPI and PPI increased 1.1% in the PCE during the month, its fastest pace since June 2023.

On the positive side, inflation tied to leisure and hospitality cooled significantly during the month, despite record travel during the Memorial Day holiday. Transportation services fell on a 2.1% drop in air fares. Hotel room rates dropped by 0.2% during the month. Recreation services fell by 0.3%, although much of that reflected a record 3.9% in drop in streaming and video rental services.  Tickets to museums receded, along with financial services, which had been accelerating in response to higher rates.

The Fed needs to see more cuts in goods prices to feel “confident” that inflation is returning to its 2% target. The good news is that consumers have become more discerning and are pushing back but not pulling back on price hikes. That leaves retailers room to cut prices on goods and make up what they lose in margins on volumes.