While U.S. consumer price inflation was slightly weaker in July than expected and the headline inflation rate of 0.8% year-over-year remained well under the Federal Reserve’s longer-term inflation goal, the underlying trends indicate inflation is likely to accelerate toward that goal.
Previous declines in commodity prices and the lagged impact of currency appreciation continued to weigh on the headline Consumer Price Index (CPI) number reported on Tuesday. However, underlying components that are more sensitive to domestic fundamentals and labor market slack remain supportive of higher inflation.
Moving forward, as the drag from past commodity price declines and dollar appreciation begins to fade, headline and core CPI inflation should gradually converge to a 2.2% annual run rate, a level that is more consistent with the Fed’s 2% PCE inflation goal.
Federal Reserve officials and market participants tend to focus on core inflation – a measure of inflation that excludes more volatile food and energy prices – because it has been a better indicator of domestic economic conditions. However, more recently, even core inflation measures have been impacted by non-domestic factors.
Core goods prices, a subset of the core CPI basket that makes up 25% of core inflation, are driven by import prices, which fluctuate with the exchange rate. Over the last few years, the broad trade-weighted dollar index has risen approximately 18%, and that has contributed to a 0.5% average annualized decline in core goods prices over the same time. (We estimate that each 10% rise in the dollar reduces core CPI inflation by 0.2–0.3 percentage points.) Moving forward, with the dollar having stabilized since the start of this year, we expect goods price deflation to fade.
Despite the decline in core goods prices, core service inflation has remained firm. Excluding what appears to be a one-off decline in airfare prices, service prices rose 0.26% in July, leaving the year-over-year rate steady at 3.3% (see chart).
Over the last year, core service inflation has accelerated from a 2.5% to 3.3% annual rate and the acceleration appears consistent with the substantial decline in labor market slack. Indeed, the relationship between services inflation and labor market slack appears to be moving to a steeper portion of the Phillips curve. Service price inflation has also been boosted by medical care services, which reflect price adjustments in “out-of-pocket” medical care costs in the wake of federal regulation. Looking ahead, we expect the recent run-up in medical care service prices to moderate somewhat, but as labor markets continue to tighten, core services should remain firm.
Putting all of this together, despite the slightly disappointing headline number, the underlying strength of core CPI reinforces our confidence that inflation process is functioning as expected and U.S. inflation is gradually moving toward the Fed’s inflation target.