US - The tide is turning

Core CPI inflation came in at 0.2% m/m in May, offering a pleasant surprise after a hot first quarter. The figure annualized to less than 2.0% for the first time since March 2021, and led to a drop of y/y inflation to 3.4% from 3.6% in April. The downward surprise was driven by price decreases in transportations services, particularly airfares and car insurance premia. Housing inflation on the other hand, remained at high levels at 0.4% m/m, and we expect it to remain elevated for most of the year. Fundamental inflationary pressures in the housing market remain benign, and as such it is a matter of time for post-pandemic price increases to fully pass-through, giving the Fed little reason for concern. The surprise in CPI inflation, and the low core PPI figures (0.0% m/m) released this month, bode well for the PCE inflation releases later this week.

This month’s FOMC meeting fell on the same day as the CPI release, which meant that the June projections and dot plot did not fully reflect the latest reading. The dot plot showed a roughly equal split between one or two rate cuts before the end of the year, down from three in the March dot plot. Chair Powell offered a balanced performance, largely aimed at tempering the market reaction to inflation figures, playing down the importance of a single number. This was similar to how – going the other way – he played down the negative impact of inflation figures in the May press conference. Powell reiterated that, ‘if the labor market were to weaken unexpectedly, or inflation decrease more rapidly, the committee stands ready to respond.’

What is the case for either surprisingly benign inflation, or a surprisingly weak labor market? In their baseline projections, the median FOMC member puts inflation at 2.8% at the end of the year, the path pushed horizontally by base effects stemming from low inflation in the second half of 2023. Powell acknowledged this to be a ‘conservative’ forecast. We expect 0.2% m/m inflation readings to continue, putting core PCE inflation at 2.6% y/y by year end, a position which Powell referred to as ‘a good place to be’ in the June press conference.

The median FOMC member projected a similarly flat trajectory for unemployment, forecasting 4.0% at the end of the year, its current level. Data on the labor market has been difficult to make sense of, with an increasing divergence between different metrics. In particular, employment based on the establishment and household survey has diverged considerably in recent years. We expect the majority of the ultimate reconciliation of the two to come from a downward revision in non-farm payrolls, and estimate that the monthly pace of job creation this year has been closer to 90k than the current BLS estimate of 247k (link). Crucially, a BLS note outlining the magnitude of such revisions for 2023 data is scheduled to be released in August, before the September FOMC meeting. This, combined with the recent rise in the unemployment rate, will likely drive a downward adjustment to the Fed’s assessment of the labor market. Alongside benign inflation trends at that point, we expect this to trigger an easing cycle.