US June data in particular beat expectations, with the magnitude of the stimulus softening. Prices have come down, but we still think it’s too high. We predict a long hiatus from the Federal Reserve.
US inflation is lower than anyone expected.
Today’s consumer price inflation report for June was much softer than expected. US headline prices fell -0.4% month-on-month vs. consensus expectations for a -0.1% result, while (ex-food and energy) was flat on the month vs. expectations for a 0.2% rise. To three decimal places, it was a negative print of -0.017% MoM. As a result, the annual headline inflation rate eased from 4.2% to 3.5% year-on-year while core inflation eased from 2.9% to 2.6%.
Details show that petrol prices fell by 9.7% MoM, but education and communication also fell by -0.8% MoM, used cars (-0.2%), apparel (-0.6%), medical care by 0.1% while shelter, the largest component within the CPI, rose by just 0.1%. New vehicle prices were flat in the month, while other goods and services rose just 0.1 percent. The only real source of strength was entertainment (+0.5%), which may reflect the World Cup to some extent. The encouraging aspect of the report is the extent of the easing — it wasn’t a sharp drop in one or two components that offset strong price increases elsewhere. The chart below shows core inflation metrics with the black line representing 0.17% MoM, the run rate needed to bring core inflation to 2% YoY.
Kevin Warsh’s testimony says all the right things.
Expectations for a Federal Reserve interest rate hike had been building in recent days, reflecting a re-escalation of the Middle East conflict, disruptions to shipping through the Strait of Hormuz and rising oil and prices. However, today’s relatively soft inflation result reflects a broad-based easing of price pressures, leading to a sharp reversal with headlines up 6bp and down 10bp. Yesterday, a July rate hike was seen as a coin toss, but is currently priced at less than 4bp of a possible 25bp rise. As of today’s open, a 50bp hike was expected by March next year, but has since fallen to 44bp by April.
At the same time, we have been released the text of Fed Chair Kevin Warsh’s semi-annual monetary policy testimony to Congress, scheduled for 10:00 a.m. It largely echoes his June FOMC press conference. The headlines say all the right things about being cautious and ready to take action to ensure a return to the inflation target – ensuring that “the rise in inflation over the last five years will be a thing of the past”. What the headline news outlets are focusing on is that he and the FOMC have “no tolerance” for persistently high inflation, which shouldn’t really be new ‘news’ for the Fed as a primary role to maintain price stability. As we expected, there is little that can be described as ‘forward guidance’, given his distaste for it. Commenters will focus on today’s CPI print Q&A – they will certainly welcome it, but will likely insist that a series of cold prints will be needed.
Four Reasons Why Inflation Will Slow in 2027
The deterioration in the situation in the Middle East has knocked shipping traffic through the Strait of Hormuz after its recent recovery and is putting pressure on oil and natural gas prices. After all, $80/bbl is historically consistent with retail gasoline prices of about $3.75/gallon, below current levels of $3.85. If talks resume, and a deal is reached, we should see oil and gasoline prices drop again.
A second, and more important, reason for us to expect inflation to remain subdued is housing. As Fed Chair Kevin Warsh said at the June FOMC press conference, monetary policy doesn’t seem constrained when considering the strength of financial markets, but it does in light of the housing market. This is significant, given that the most heavily weighted component in the CPI is shelter, at 35%. Shelter inflation is currently running at 3.3% year over year. With home prices up barely 1% and rents rising, we expect this dominant housing component to continue to put downward pressure on headline inflation over the next 12 months, according to data from Zillow and Realtor.com.
Third, there are undoubtedly issues around semiconductor prices, but the biggest cost to US corporates isn’t tech, tariffs or energy. This is the labor cost. We’ve gone from a situation where, in 2022, there were two job openings for every unemployed American to the balance today. This has taken a huge amount out of wages. Additionally, the drop in quit rates – a measure of labor market change – means that companies no longer have to pay to retain staff. Wage inflation of 3% is perfectly consistent with 2% consumer price inflation.
Then, rounding out the story, we have tariffs. They represent a one-way change in prices. Now that we have reportedly entered into a less onerous tariff regime with many loopholes, we are increasingly confident that their upward impact on inflation will quickly dissipate. The Dallas Fed believes that tariffs are contributing about 0.9pp to the annual rate of the core PCE deflator. As it falls to zero, core inflation should come down sharply. Additionally, federal budget balance data shows that IEEPA ‘Liberation Day’ tariffs, which were struck down by the Supreme Court, are now being paid to corporate America. In May the Section 301 tariffs (new regime) were fully phased out by early payments of IEEPA tariffs. In the figures for June yesterday, the Treasury actually paid $25.5bn more in IEEPA refunds than it received under all other tariffs. With perhaps another $80bn of repayments yet to come, this increase in corporate cash flow will also help limit consumer price hikes.
A longer break for next summer is our call.
We recognize that the Fed has missed its inflation target for the past five years, and Kevin Warsh wants to reverse that trend. Nonetheless, consumer inflation expectations remain within tolerable limits, suggesting little risk of second-round price effects from the energy surge. Meanwhile, the market’s inflation expectations have fallen, with inflation in line with their 25-year average over a 10Y interval, while the 2Y inflation rate has fallen below 2%. In our view, the Fed is more likely to keep rates on hold for a longer period of time, perhaps until the summer of next year.
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