Upside inflation surprise keeps pressure on the Fed

Inflation surprised once again to the upside in June, both headline and core measures, with annual inflation jumping to a new four decade high of 9.1%, up from 8.6% in May. As we had expected, a further rise in petrol prices as well as pass-through from natural gas to utility gas prices was responsible for the bulk (more than half) of the rise in inflation, but food prices and core inflation also surprised significantly to the upside. Indeed, the firming in services inflation – which has been running at around 0.7% m/m for the past three months, i.e. more than three times the pre-pandemic monthly pace – is especially worrisome, as this is a much stickier component of inflation than volatile food and energy components. All told, we think monthly headline inflation is likely to fall back in the near term given the decline in a range of commodity prices, but the risks to core inflation look still to be to the upside, despite the cooling in demand indicators. 

Tentative signs of pipeline pressures easing...

While we expect core inflation to remain firm over the coming months, there are some tentative signs that we are on the cusp of a turnaround in headline price growth. First, non-energy commodity prices (especially food and base metals) have fallen more than 20% from their peak in March, while energy prices have also fallen back, albeit more modestly (note, the US has not been subject to the same surge in natural gas prices and electricity prices as in Europe). The reprieve for petrol prices is unlikely to last, as we expect oil prices to rebound over the coming months. But the broader decline in commodity prices should help put downward pressure on headline inflation, and even with core inflation elevated this will reduce the risk of expectations becoming unanchored – the chief concern of Fed officials right now. Second, as was confirmed in Friday’s payrolls data, wage growth has cooled from the elevated levels seen earlier in the year, and despite the strength evident in payrolls last week, survey indicators suggest we are likely to see a fall in labour demand over the coming months. Third, while retail inventories broadly remain well below pre-pandemic levels, bloated inventories in some consumer-facing segments is likely to lead to some modest discounting, leading to a decline in goods inflation. 

…but Fed will be in no rush to declare victory in inflation fight

As the upside surprise in today’s data served to emphasise, there is enough uncertainty in forecasting at present that even with pipeline pressures easing, the Fed will be in no rush to signal a pivot from its current path of aggressive rate hikes. At the June FOMC meeting, Chair Powell stated that he would need ‘compelling evidence’ that inflation is easing for the Fed to change course, which he defined as ‘a series of falling monthly inflation readings’. Despite the slowing in demand that we are now seeing, and the risk of recession, the Fed is clearly more worried about a de-anchoring of inflation expectations, which would be much harder to deal with. Indeed, at the Sintra conference in late June Powell said that ‘while there’s a risk the Fed could overdo it [with rate rises], that is not the top risk – the bigger risk is failing to restore price stability’. We continue to expect the Fed to raise rates by 75bp when the FOMC next meets on 26-27 July, with this followed by 50bp hikes in September and November, and 25bp hikes in December and February – ultimately taking the upper bound of the fed funds rate to 4% from 1.75% currently.