CPI components outside the FOMC’s direct control are holding inflation at historic levels. We now see the fed funds rate at 4.125% by year end.
A near 11% decline in the price of gasoline kept the headline CPI to a weak 0.1% gain in August despite stronger-than-expected food prices, and resulted in the annual rate declining to 8.3%yr from 8.5%yr in July and a cycle peak of 9.1%yr in June.
Completely against expectations however, the core CPI printed at a strong 0.6% (0.33% consensus), lifting its annual rate from 5.9%yr in July to 6.3%yr in August, albeit still inside of the 6.5%yr peak of March 2022. Of particular concern is that the August core reading, at 0.57%, is higher than the average monthly rise in the core over the last 12 months of 0.53%.
Of the components of core inflation, price increases related to the essentials of life (shelter, medical care, insurance and education) drove the result. Inflation related to household furnishings and new cars also arguably surprised to the upside; though these gains were moderated by a second-consecutive (admittedly very small) decline in the price of used vehicles (-0.1% in August following July’s -0.4%). Pointing not only to the passthrough of lower energy prices but also arguably a reduction in demand, airline fares declined 4.6% after a 7.8% fall in July.
Taking a broader view and looking at the 6-month annualised contributions of key categories. helping to bring the pace of inflation down: supply disruptions and support from fiscal policy have largely abated, with August’s 0.8ppt contribution for goods ex energy and food unchanged from July and only a quarter of its September 2021 peak of 3.2%; also, at August, energy and transport’s 2.8ppt contribution was less than half that seen at the June 2022 peak, 6.6ppts. Holding inflation up, however: shelter inflation continued to rise at a historic pace, the 6-month contribution rising from 2.2ppts to 2.3ppts in August; and food inflation remained sticky, its contribution little changed at 1.7ppts. The change in the contribution from medical, education and other services meanwhile was negligible in August, the sum of these components continuing to contribute 0.7ppts on a 6-month annualised basis.
Clearly, this CPI report will test the resolve of the FOMC. Prices outside of their direct control (shelter and other essential services as well as food) are holding inflation up while price pressures for categories of consumption driven by demand such as other goods are airline fares are dissipating, admittedly to varying degrees. Moreover, for shelter and food, it is very difficult to work out when inflation will meaningfully abate, with higher interest rates, the tight labour market and material shortages continuing to encourage landlords to increase rents at an above-average pace, and the food supply chain subject to not only first but second and third-round price shocks from commodity, packaging and labour costs.
Factoring in the recent rhetoric of the FOMC, it now seems most appropriate to forecast a 75bp increase at next week’s September meeting to be followed by 50bp hikes at both the November and December meetings. That would take the fed funds rate from 2.375% today to 4.125% at year end. The scale and persistence of the contributions from shelter and food also points to the FOMC holding to their hawkish resolve through 2023, with rate cuts not beginning until early-2024.
This will all come at a cost, however. Since the FOMC’s rate hikes began this year, we have been of the view that growth would materially disappoint. As the FOMC have ratcheted up the pressure, the activity data has largely supported this view. We now anticipate cumulative growth through 2022 and 2023 of just 0.6%, leading to an output gap of more than 3.0% by end-2023 compared to the pre-pandemic path. Given the lags with which policy works, this output gap is likely to widen further in 2024 and sustain thereafter. The consequence is likely to be the impairment of productivity and real income into the medium-term, restricting US consumer demand and investment in productive capacity alike.
