US inflation boosts case for no further rate hikes

The US consumer price inflation report showed that prices rose 0.2% month-on-month at both the headline and core (ex food and energy) level as was expected. To two decimal places it was even better at 0.17% and 0.16% respectively, which meant that the annual rate of headline inflation came in at 3.2% rather than 3.3% (versus 3% in June). Core inflation slowed to 4.7% from 4.8% as expected.

A decent drop in used car prices helped (-1.3% MoM), but a second consecutive large decline in air fares (-8.1%) is a bit of a surprise. With medical care (-0.2%), recreation (0.1%), education (0%) and other goods and services (0.1%) all very subdued the Federal Reserve has got to be pretty happy with this. That so-called 'supercore' services (services ex energy ex housing) looks like it comes in at around 0.2% MoM, although the year-on-year rate ticks higher a little due to base effects.

Housing costs rose more than we thought though, with owners’ equivalent rent (the largest CPI component with a 25% weighting) rising 0.5% MoM/7.7% YoY but all in this report supports the nice golidlocks scenario of a slowdown in inflation allowing the Fed to stop hiking and eventually cut rates next year, which catches the slowing economy in time to prevent a recession. Obviously a lot can go wrong and we think it probably will given the worries about the abrupt slowdown in credit growth, but for now this data is encouraging.

Unfortunately we are likely to see headline annual inflation rise further in YoY terms in August, albeit modestly. This will largely reflect higher energy costs, but we suspect it will resume its downward path again by October. Core inflation won't have this problem as the 0.6% MoM prints for August and September last year will drop out of the annual comparison to be replaced by 0.2% readings we predict, allowing annual core inflation to slow to below 4% by September.

This is going to be increasingly driven by the all-important housing components, which are set to slow sharply based on observed rents while used car prices are set to fall further based on auction prices. Consequently we are increasingly confident of a sub 3.5% YoY core CPI print by year-end. We had been hoping that headline inflation could be around 2.5%, but the rise in oil and gasoline prices over the last couple of months makes this look less achievable.

In fact there has been some talk that the rise in energy costs will make the Fed more inclined to hike rates since it will push up inflation with rising costs potentially passed onto other components such as logistics and airline fares. We are not that concerned though since it can have a disinflationary effect elsewhere because higher energy prices can be viewed similarly to a tax. You can't avoid filling up your car with gasoline and you can't not heat your home etc so it effectively means you have less money at the end of the day to spend on other goods and services. It hurts economic activity and effectively intensifies disinflation in other components over time. As such the Fed will be watching and waiting to see what happens rather than any knee-jerk hike action.

Moreover, business surveys continue to point to weakening pricing power, such as the ISM services index being consistent with 1% headline CPI and the National Federation of Independent Business survey pointing to core inflation heading to 3% by year-end. Such an inflation backdrop should allow the Fed to respond to any recession threat with interest rate cuts next year.