I know, I said this last month. But this month was not only the best inflation report of the year, but probably since the depths of COVID. The good news and bad news is today's report was encouraging enough that you probably won't have to hear me say this again for a while. Let's go through it.
May headline CPI (which includes food and energy prices) was unchanged on the month, while core CPI (which excludes food and energy prices) increased 0.2% (0.17% unrounded). The core 17 bps month-over-month, and seasonally adjusted increase compared to consensus estimates of closer to 0.3-0.35%, so it was a considerable beat. The delta appears to have been largely in core services ex. shelter (or "Super Core" as the Federal Reserve likes to say), which actually contributed -1 bps this month, the first time core services has been negative since August 2021. Goods contributed 0 bps this month after being slightly negative in the prior two, and Shelter contributed 18 bps, the fourth straight month that bucket has contributed 18 bps. Today's upside surprise resulted in the year-over-year inflation figures ticking down in both the headline and core, to 3.3% and 3.4% respectively. As we'll discuss in a moment, while these figures are still well above the Fed's 2% inflation target, "run-rate" inflation (that is, inflation in the economy today) is likely to be considerably below that.
Here are charts of our three buckets that we show each month on Goods, Services ex. Shelter, and Shelter compared to their Pre-COVID averages.
Encouragingly, underlying inflation appears to be just as benign. As readers of these posts will know by now, one thing I like to do is to look at category inflation to get a sense for inflationary breadth. If more categories are inflating at 4% or 5%, and fewer are inflating at 1% or 2%, but those categories that are inflating at 1% or 2% have greater weight in the CPI, that actually might suggest underlying inflationary breadth is greater in the economy than the CPI would suggest. And vice-versa if the opposite was true. We look at this by examining what I call "Category 4" and "Category 5" level data from Table 2 of the CPI's Supplemental Table of Contents. As a reminder, Category 4 level data is perhaps the most significant, as it comprises 55 baskets of goods and services that account for 98% of the core CPI. Category 5 level data has more baskets (101), but only comprises about 78% of core CPI. Nonetheless, both are useful to look at.
This month, similar to last month, showed continued deceleration in inflationary breadth. This month's Category 4 and Category 5 level averages were actually decreases of 15 bps and 16 bps, respectively, while the median changes for goods and services baskets in Category 4 and Category 5 were 0. This compares favorably to last month's 12 bps average increases and 10 bps median increases for Category 4 and 5 respectively, which themselves are good enough to suggest we're close to, if not at, the Fed's 2% inflation target.
The charts below help demonstrate this. As a reminder, gaps between the lines and the bars suggest category level data is inflating at faster or slower paces than the (core) index in general. Over the last 4 months, category level inflation has been routinely less than the index in general (hence the lines are below the bars), predominantly due to the Shelter component of CPI's large weight and overall stubbornness in coming down. Consequently, our inflationary breadth indicators are telling us that inflation is very much moving in the right direction, with the shelter component of the CPI continuing to bring up the rear.
If you take those inflationary breadth figures and take a 3 month average, and then annualize them, you again actually get inflation below the Fed's 2% target. The grey bars are again well above the lines, largely due to shelter's stickiness and larger representation in the CPI. As we've talked about in prior posts, however, shelter costs in the real economy (best evidenced by rent costs), are inflating only modestly at best, and in many cases are actually going down (or deflating). See here and here for a couple good data sets on this.
With shelter inflation in the real economy generally near 0, the more encouraging CPI prints in the last two months make it reasonable for us to again say that we're probably very close to the Fed's 2% inflation target, if we're not there already. As noted above, despite the reported year-over-year figures remaining high (~3.3-3.4%), this is due to base effects, and not representative of where the economy and inflation are at the current moment. If we normalize for Shelter, and assume it's increasing at pre-COVID rates (even though it's not: it's increasing below pre-COVID rates), we can get a sense of "underlying" or "run-rate" inflation. The below chart seeks to do just that, and shows 1, 3, and 6 month averages for goods, core services, and then pre-COVID shelter inflation. As of May's CPI report, the 1 month annualized figure stands at about 1.3%, the 3 month stands at 2.89%, and the 6 month stands at about 3.04%. If you use true on-the-ground shelter inflation, those figures are even lower.
Coming into this release, companies across sectors had been much more understated about the economy during 1Q earnings season, and many industrial distributors had actually been talking about de-flation rather than a resurging in-flation. The fact that few, if any companies were talking about either labor or price inflation accelerating in the first quarter of this year made a lot of us skeptical about whether seasonal adjustments and other mechanical adjustments at the BLS (Bureau of Labor Statistics, which puts out the Consumer Price Index each month) was producing more "noise" than "signal" in the 1Q data. Today's release gives us more confidence that was the case, and the Fed's (appropriate in my judgment) stance has generally been of that same view (that 1Q's inflation increase was likely more noise than signal). May's CPI data should help allow them to stay the course they've been on recently, which is patiently pursuing rate cuts.
While the Fed will likely give itself a few more months to see if these more encouraging inflation trends continue, the odds of interest rate cuts later this year went up again today. The election still complicates things, but if we were to get even one more month like this, it's likely the Fed would cut rates sooner rather than later. We've all learned not to get too excited (or deflated, pun intended!) about one month of data, but today's report was a solid step in the right direction, especially considering last month's report was better than it looked, and also considering what seems to be a weakening labor market and economy in general in recent months. Many of us (including myself) had begun to worry that the Fed didn't see the actual weakness in the economy the last couple of months (especially regarding the consumer), but now that they have this inflation report in their quiver, it reduces the odds of a policy mistake by giving them more of an opening to actually reduce rates and support a softer economy. We'll likely need at least one more month of good data to underwrite that, however, so check back next month to see how June shakes out.
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