May Inflation Report Shouldn't Change The Fed's Mind

Earlier today, the Bureau of Labor Statistics released the Consumer Price Index for the month of May. The report is the first of two popular reports used to gauge price inflation in the economy. The results were mixed as headline inflation plummeted to 4.1% year over year, down 0.9% from last month. Core inflation remained stubborn at 5.3%, down 0.2% from last month.

After two years of higher headline inflation than core inflation, the trend has reversed over the last couple of months. The 120-basis point discount in headline inflation is led by a large drop in energy prices. Food inflation continues to decline, but still remains robustly over 6%. Economists hope that the deflationary pull in energy pricing will spread to the broader sectors over the next several months.

Despite the stubborn nature of the core CPI number, there was some promising data within the inflation report. First, nondurable goods, which are products that are disposable in nature, saw their price increase decline to just 1% year over year. This was the best reading in nearly two and a half years. Housing, which has seemed particularly stubborn with increased inflation up to January of this year, recorded its fourth consecutive month of disinflationary activity.

Yet, challenges remain in the Fed’s battle for price stability. Service sector pricing, despite dropping for the third consecutive month, remains elevated at 6.6%, just 0.7% away from its cyclical highs. Rent inflation finally dropped for the first time from its cycle high, but only by 0.1%. At 8.7%, rent inflation is far above any measures of price stability.

What may be most concerning is that there is nothing in the last twelve months of inflation data to show that core inflation is making any further progress. Currently, the last three months of inflation reports annualized is at 4.9%, and it represents the best possible near-term floor for core inflation. With progress moving slowly, it appears as if 2% core inflation may be more than two years out (at this rate).

As for the Federal Reserve meeting tomorrow, I do think the committee will hold steady on rates, mainly because that was telegraphed into their economic projections back in March. However, do not be surprised if the Fed projects a 25 basis point increase into the forecasts for later this year, with a pause to follow. This would be due to the lack of progression along the Phillips Curve when it comes to both inflation and unemployment. While May’s readings in both areas moved us in the right direction, they are far off from the Fed's most recent 2023 estimates and even further away from the long-term targets.

The June inflation report is likely to bring another downward drop in headline inflation as June 2022's 1.2% month over month inflation number will fall off the report. It is quite possible that we may be looking at a 3.0% headline number next month, but with energy being the primary driver behind disinflation, these trends can only continue if we see broader improvement in other pricing categories.

Overall, the May inflation report represents a slow step in the right direction. The Fed will need to determine tomorrow whether the pace of disinflationary activity is acceptable or not. This communication point, combined with the latest economic projections, are what I will be looking for from the committee tomorrow.