What Happened?

US inflation decelerated in June. Core CPI rose 0.2% month-over-month (MoM), below expectations. The shorter-term run rates for core CPI make clear that there is underlying downward momentum. Still, there is a long way to go: even after today’s low point, the core CPI index ran at a pace roughly double the Fed’s inflation target in the second quarter.

Details

The details of the data are consistent with recent trends: goods prices are close to flat and services prices remain elevated. That said, there is clear progress toward service price normalization—broader services prices have decelerated by two percentage points in the last few months. Stabilizing wage growth is having the expected impact on the run rate of services inflation. Excluding shelter, the run rate of services inflation is now back below 4.0% in year-over-year (YoY) terms.

One of the key planks of ongoing disinflation has to be a deceleration in shelter costs. Encouragingly, that is exactly what we are seeing: both the broader measure of shelter inflation and owners’ equivalent rent have turned lower. Shelter remains the largest single contributor to inflation—by itself it is adding more than 2 percentage points to the series. The good news is that the contribution has moved decisively lower. We expect that to continue as last year’s fall in house prices feeds through.

One of the big stories this month was a fall in used car prices. There had been a disconnect in the timing of used car prices at auction and the feed through to the CPI series. After a fall in June in the CPI measure, the relationship appears more or less back to normal, though there may be a bit more room for the CPI measure to “catch down” to other indicators.

Headline Inflation 

While we have largely been discussing core inflation because it is policy relevant, the decline in headline inflation is an important economic event, and there is likely more to come. While base effects suggest stability or even a modest increase in YoY headline inflation through July, the trajectory of gasoline prices means that one should expect YoY headline inflation to fall later this year. And falling headline inflation acts essentially as a subsidy to households: less money being spent on perishable goods means more money in “real” terms.

As that process plays out, real incomes will rise: wages are running above inflation, and the robust rate of hiring means that the economy-wide, aggregate paycheck has inflected upwards. That upward inflection is good reason to expect consumption to remain a key plank of growth, and it is good evidence supporting the sort of mild recession/soft landing that we expect. Of course, that strength also means that the Fed has to remain vigilant: if incomes rise too much, the economy might not slow enough to bring inflation back to target. Hence our expectation that we are in for a protracted period of elevated interest rates (think first cut not until March 2024 or so).

Fed Policy Implications

The deceleration in the June CPI data, while welcome, will not be enough to dissuade the Fed from raising rates at its meeting later this July—we still expect a 25bps increase on July 26. After that it gets more interesting. The Fed’s dots suggest an additional hike later this year; our forecast and market pricing do not show that additional hike.

Today’s data are not determinant—there are several more inflation and labor market data points between now and the Fed’s September and November meetings. But with both payrolls and CPI having come in softer than expected this month, certainly the most recent data support the idea that the Fed might be done after this month’s meeting. But it is not a foregone conclusion: even after today’s encouraging print, there is a long way to go before core inflation is back to target, and the Fed won’t want to undo the progress it has made by becoming too dovish too soon. The Fed is data dependent, and it will take more than one month of data to convince them.