Another soft U.S. core Consumer Price Index (CPI) inflation report – the third in a row that has lagged expectations – could complicate the Fed’s intentions to raise rates one more time this year, as the central bank’s Summary of Economic Projections currently forecasts.
May’s inflation weakness was broad-based across goods and services categories (but more pronounced for core goods) and will be more difficult for Fed officials to dismiss as a “one-off.” Core CPI’s weak 0.06% month-over-month advance in May lagged the 0.2% trend and followed a soft advance in April (0.1%) and an outright price decline in March (-0.1%). The March deflation resulted primarily from a large (-7%) one-off adjustment in wireless communication services. However, the weakness in April and now in May isn’t attributable to any single story, and therefore should be more worrying to Fed officials, who were already struggling to meet their inflation target.
Core CPI is now running at 1.7% year-over-year, and we expect core Personal Consumption Expenditures (PCE) to fall another 0.1 percentage point to 1.4% when the May PCE report is released. Although we don’t expect a further deceleration, our year-end forecast for 1.5% continues to be under the 1.7% median projection of Federal Open Market Committee (FOMC) members, and as a result appears more consistent with just two fed funds rate hikes in 2017. (For more on the Fed’s recent action, read Richard Clarida’s blog post here.)
Core goods drop
Core goods prices fell an additional 0.27% month-over-month, and core goods excluding medical care and autos declined 0.4% – the largest one-month decline in this subcategory since the 2008 financial crisis. Household furnishings, apparel, recreational goods, and education and communication all showed declines, and while new and used auto results were also weak, they were in line with recent trends. Wholesale auction prices for used autos tend to lead the CPI by three months, and these prices are deflating 7% year-over-year. The glut of new car leases over the past several years is now weighing on used car prices, and new car inflation is languishing as dealers ramp up incentives amid moderating sales growth.
Core services underwhelm
Core services inflation, at 0.16%, was a little firmer than core goods but still below recent trend inflation of 0.25%. Owners’ equivalent rent, the largest component of services inflation, has started to decelerate amid the glut of multifamily housing in major cities. Before the March report, rental trends in less urban areas had been accelerating, somewhat offsetting the moderation in large cities, but more recently the moderating trend has extended to these areas as well.
Finally, medical care services were also soft, with a 0.1% decline. The acceleration in medical inflation last year reportedly resulted in part from industry efforts to push high-deductible plans as a way to foster more price sensitivity among individual plan holders. These efforts raised prices last year, but the strategy appears to be working: Medical services prices are now growing just 1% year-over-year, down substantially from the 3.1% pace in December 2016.
Bottom line? Despite diminished labor market slack, inflation is coming in below where the Fed wants it to be.
Readers interested in the interplay of inflation and rates can learn more at our Rise Above Rates page:
Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.