US inflation cooled in June with the annual CPI rate falling to 3% from 4% in May. Base effects were helpful as increases in energy prices from a year ago dropped out of the index, nonetheless the monthly change came in at the lower end of expectations, rising just 0.2%. The same can be said for the core rate (CPI excluding food and energy) which also rose less than expected at 0.2% month-on-month.
So, with inflation fading, will the US Federal Reserve (Fed) step back from further tightening and cancel a well signalled rate rise when it meets later this month?
The Fed had said it wanted to skip a hike and pause in June so as “to assess additional information and its implications for monetary policy”, but their intention was still to raise in July. The dot plot projection of interest rates from the meeting showed that members were looking to raise rates by 25 basis points in July and September.
Today’s better-than-expected inflation figures would suggest that policy is working to ease price pressures as higher interest rates reduce demand. Last week’s key payroll figures also came in below expectations with the economy generating less jobs than expected in June.
We will hear from more Fed officials this week, but our sense is that they will go ahead and raise rates later this month for two reasons.
First, there are still worries about inflation and the labour market. Underlying inflation rates remain elevated. Although coming in below expectations the core rate was running at 4.8% year-on-year last month, still well above the Fed’s target.
And the labour market remains tight. Unemployment actually fell last month to 3.6% well below estimates of equilibrium or the NAIRU, the Non-Accelerating Inflation Rate of Unemployment, and the ratio of job offers to unemployed was running at a hot 1.6 in May. The labour market is cooling, but is still tight enough to accommodate strong wage growth. Such second round effects have the potential to perpetuate inflation by raising labour costs across the economy which the Fed will be keen to avoid.
The second reason is that to reverse now would trigger a rally in bond markets which would loosen financial conditions. Such a development would help support activity and offset the overall restrictiveness of policy. Given the efforts the Fed has made to convince markets they were serious about inflation and not about to pivot this would seem to be too early.
Our view is that we will still see a rate hike in July. The debate will intensify though and we do not expect a move in September. The next move should prove to be the last hike in this cycle with cuts following thereafter. Fed chair Powell may not be skipping, but he will have more of a spring in his step after today’s figures.