Core CPI Hits A Cycle High

Headline CPI Misses & Core CPI Beats

The August CPI report doesn’t change anything about near term Fed policy. It only alters my thinking on the economy slightly. These slight changes drive the day to day action, so they aren’t something to gloss over. Specifically, headline CPI was weak as it was 0.1% monthly which met estimates and was below the 0.3% rate in July. It was 1.7% yearly which met estimates and fell from 1.8% as you can see in the chart below.

Headline inflation was weak mostly because of energy as energy prices fell 4.4%. Food inflation was 1.7%. This modest decline in headline inflation combined with the increase in wage growth in August is great news for real wage growth. It improved which means consumers will be is solid shape to deal with the tariffs. If there is an interim trade deal like some speculate, then there is clear path to a solid holiday shopping season.

Core CPI was much stronger than headline inflation as it wasn’t dragged down by energy. Monthly core CPI was 0.3% which beat estimates by 0.1% and met July’s reading. Yearly core CPI was 2.4% which beat estimates for 2.3% and July’s reading of 2.2%. This is the highest core CPI reading since September 2008. Technically, the 2 year stack barely increased. This burst in core CPI was mostly due to an easier comp. The 2 year core CPI stack increased from 4.54% to 4.57%. From November 2018 to May 2019 core CPI fell from 2.3% to 2%, so easier comps are coming.

This increase in core CPI is making some question the Fed’s coming rate cut in September. Despite this increase in core CPI looking bad, core PCE inflation is still below 2%. The Fed will cut rates next Wednesday. There is an 88.8% chance of a cut. The best chance of the Fed stopping rate cuts after September is for there to be a trade deal and a subsequent increase in consumer and business sentiment.

This report gets at a point I have made previously. Namely, if there is a trade deal and a burst in economic activity, the Fed will have an inflation problem. Even with the slowdown and trade war, core CPI is above 2%. Core PCE will face easier comps early next year which could bring it above 2%. It’s possible the Fed will hike rates next year. That’s not necessarily a disastrous situation though. It would signal the economy is re-accelerating.

Details On CPI: Big Increase In Medical Care Services Inflation

With comps set to get easier this fall, headline CPI won’t be dragged by energy much longer. There are 2 more months where energy will significantly hurt headline CPI assuming oil prices stay in the recent range of the $50s. Oil peaked at $76 in early October last year. Yearly energy inflation in September will be ever lower than August, but in November and December it will probably be positive. In the August report, fuel oil prices fell 8.4% and gasoline prices fell 7.1%. Natural gas (piped) fell 3.5%. Food at home drove down food inflation as prices were only up 0.5% while food away from home was up 3.2%. Full service meals and snacks inflation was 3.4% and limited service inflation was 3.1%. This strength could be related to the tightness in the labor market and minimum wage hikes at the state level.

The focus in this report is the jump in core CPI, so let’s look at the details there. Core commodities inflation was still low as it was 0.5%. There was a big burst in tobacco and smoking products prices as this inflation was 5.6%. It might be related to vaping devices. New vehicle inflation was only 0.2% which is good for those buying cars after they were impacted by hurricane Dorian. Because Dorian didn’t make a direct landfall in Florida at its peak, I don’t anticipate major impacts on economic data. Used vehicle inflation was 2.1% which is still manageable.

Core services inflation of 2.9% drove core inflation to new heights. As you can see from the chart below, core services CPI was 2.9%. It’s actually below its 2018 peak despite the tightness in the labor market. This isn’t consistent with average hourly earnings growth as wage growth is currently 3.2%. In July 2018, core services CPI peaked at 3.1% and wage growth was 2.8%. In August 2016, core services CPI peaked at 3.2% and hourly wage growth was just 2.6%. Medical care services inflation drove the spike in 2016 and shelter inflation drove the strength in 2018.

While shelter inflation has been important to driving core CPI this cycle, that wasn’t the case in the August report. Shelter inflation was 3.4% which fell from 3.5%. Medical care services inflation drove core CPI as it increased from 3.3% to 4.3% which is its strongest reading since September 2016.

What Core CPI Means For Core PCE Inflation

Core CPI won’t change the Fed’s decision to cut rates because it follows core PCE inflation. The August PCE report comes out on September 27th which is after the Fed’s meeting. Economists don’t believe the spike in core CPI inflation will lead to a big increase in core PCE inflation because CPI covers out of pocket expenses while PCE covers payments made on your behalf. As you can see from the chart below, PPI on selected healthcare services was weak which implies weakness in PCE healthcare services inflation. In August, core PCE inflation will be below 2%.

Conclusion

The decline in headline CPI is great for real wage growth. The increase in core CPI might continue the selloff in treasuries. The Fed won’t stop cutting rates because of inflation since core PCE inflation is below 2% and will stay that way for the rest of the year. The Fed might have an inflation issue in 2020 if there is a trade deal. However, I don’t fear a re-acceleration in economic growth. The bulls should hope growth accelerates enough to pressure the Fed to reverse the 2019 rate cuts. 

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