Another underwhelming rise in the U.S. core Consumer Price Index (CPI) reported on Friday increases the chances that Federal Reserve policymakers use the September meeting to signal they plan to abstain from additional interest rate hikes until next year. After the July CPI report, we believe it is entirely possible that core PCE (personal consumption expenditures, the Fed’s preferred inflation measure) ends the year running at 1.3% year-over-year, which is meaningfully below the Fed’s June median forecast for 1.7%. Despite the dimming outlook for an additional policy rate hike in 2017, we continue to believe the Fed will begin to gradually shrink the size of its balance sheet sometime in the second half of this year.
Persistent core CPI weakness
July’s 0.11% month-over-month core CPI print was softer than consensus expectations – primarily due to the largest-ever one-month drop in hotel prices (−4.2%), which is unlikely to repeat. Still, it follows a string of weaker-than-expected reports, raising questions about the extent to which softer inflation is indeed transitory.
Meaningful trends toward weakness in core goods prices
Ingrained deflationary trends across several core goods categories continued. New and used auto prices declined 0.5%, and we expect pricing weakness to continue into the second half of the year as the auto industry works through oversupply issues. The glut of used cars coming to market after the increased pace of consumer leases over the last several years and the generally weaker-than-expected trends in business and consumer purchases of new autos have generally increased vehicle inventories and weighed on prices.
Meanwhile, deflation in retail goods prices also continued in July, in what appears to be a more meaningful trend. July’s weakness was likely exacerbated by Amazon’s Prime Day on July 11, which reportedly induced heavy discounting among other retailers. However, the broader disruption of the retail sector from rising e-commerce competition is also likely having an impact.
Services and shelter inflation more stable
On a brighter note, core services inflation excluding hotels was firmer. In line with our expectations, the heavily weighted Owner’s Equivalent Rent (OER) category advanced 0.3% month-over-month in July, as the deceleration in rental and OER inflation across major cities, including Los Angeles, New York and San Francisco, appeared to further stabilize. Shelter inflation makes up a large portion of the CPI index, so stable inflationary trends in these categories will support broader inflationary trends.
Bottom line: July marked the fifth month in a row that core CPI inflation has printed under consensus forecasts, bringing down the year-over-year core U.S. inflation rate to 1.7% versus the 2.3% peak reported in February. While this disappointing result raises more questions about the likelihood of another Fed interest rate hike this year, the nascent stabilization in shelter inflation over the last two months – after several months of pronounced softening – provides some support for our forecast that CPI inflation should return to 2.0% in late 2018.
For more of PIMCO’s views on the complex drivers of inflation in the U.S. and globally, please visit our inflation page.
Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.