Core Inflation Increases In July, Putting Future Rate Cuts In Doubt


CPI Beats Estimates

Investors were caught leaning in the wrong direction as the July CPI report differed from the PPI report. It beat estimates, putting the Fed in more of a bind than most thought it would be in. There is still a 100% chance of a rate cut in September, but this makes rate cuts in October and December tougher to do without inflation being an issue. 


Fed needs to thread the needle by supporting the economy while not having inflation get out of hand. With the July and September rate cuts just starting to impact the economy in early 2020 and comps getting easier, inflation might be stubbornly high in the first half of next year. 


Specifically, July headline monthly CPI was 0.3% which beat estimates for 0.2% and June’s reading of 0.1%. On a yearly basis, it increased from 1.6% to 1.8% which beat estimates for 1.7%. Core CPI was 0.3% on a monthly basis which beat estimates for 0.2% and met June’s reading of 0.3%. That’s pretty strong back to back readings. 


That explains why the chart below shows the annualized core inflation rate over 3 months is near its highest level in the past 4 years. Only a few readings in early 2018 beat it out. Finally, the all important core yearly CPI was 2.2% which beat estimates and June’s reading which were both 2.1%. I expected it to be 2%, so I was off.  

July CPI Details


Let’s look at the details of this report which puts a wrench into the expectations for future rate cuts. Food inflation was 1.8% and energy inflation was -2%, surprising no one. Also, not surprising is that services less energy services dominated inflation, while core commodities prices barely increased. The surprising aspect is how strong core services inflation was. Core commodities prices were up 0.6% and core services prices were up 2.8%. Once again, the breakdown of core inflation isn’t surprising, but the size of some of the increases is. 


Core shelter inflation was 3.5%. As the chart below shows, rent of shelter inflation has been leading the charge for the past few years. This is even with the past few quarters showing declines in home price growth. National Case Shiller home price growth rate of 3.4% in May is almost right in line with shelter inflation. But I expect to see that growth rate fall in 2 months when the July reading comes out. Therefore, the two really aren’t in line. Core medical care inflation was 3.3% and core transportation services inflation was 0.7%.

Let's review a few more miscellaneous inflation stats. Food at home inflation was only 0.6% and food away from home inflation was 3.2%. Meats, poultry, fish, and eggs had 0% inflation in the at home category. Both full service meals and snacks as well as limited service meals and snacks had 3.2% inflation in the away from home category. Once again, in the core commodities category, apparel inflation was low and tobacco and smoking products inflation was elevated. 


Specifically, their inflation rates were -0.5% and 5.4%. Medical care commodities inflation was low unlike that of medical care services as prices fell 0.4%. New car and truck inflation was 0.3% and used car and truck inflation was 1.5%. Finally, energy commodities prices fell 3.4% and energy services prices were down 0.2%. Fuel oil prices fell 6% and electricity prices were up 0.5%. 


Monetary Policy Takeaway


It’s difficult to have a clear takeaway from this report when you look at the markets because the new trade policy, which I will explain in my next article, impacted markets. The conclusion is simple. September rate cut has been locked in for a couple of weeks. Nothing could have changed that. Core PCE inflation will still be below 2%, but it might increase from 1.6% to about 1.7% or 1.8% in July. That pressures future Fed rate cuts. There’s a higher likelihood that the Fed will now cut rates only one more time this year (in September) and then pause cuts for a few months. 


Depending on the cyclical economy and trade policy, that might not be enough to keep the expansion going. Literally, everything is up in the air because trade policy is so uncertain. If you think it’s tough to do analysis, imagine how tough it is to make long term business decisions. So much investment has been held up. If there is an ‘all clear’ sign where we get an intermediate term trade deal which eliminates most uncertainty, I see there being one quarter where GDP growth explodes higher. Business investment will increase significantly.


Despite Trade War, Small Business Optimism Improves


This survey was done before Tuesday’s news. It's surprising that despite the bad news on trade, the July small business confidence index improved from 103.3 to 104.7. It beat estimates for 103. Remember, the June small business index showed some sequential weakness as it fell from 105. 


As you can see from the table below, the net percentage of businesses expecting real sales to increase was up 5 points to 22%. Furthermore, the net expecting the economy to improve went up 4 points to 20%. Only 2 categories showed declines as the current inventory index fell 3 points to -3% (a good sign) and the next expecting credit conditions to improve fell 1 point to -4%. When this stock market correction ends, credit conditions will improve. 


Conclusion


It may not seem like a big deal to those who don’t study monetary policy, but every tick higher in core CPI, the less likely the Fed is to cut rates (assuming core PCE moves in kind). Every Fed statement and rate change has a big impact on financial conditions, the US stock market, global currencies, and emerging markets. 
Some don’t believe the Fed cares about inflation anymore. However, just because the Fed won’t react to this increase in core inflation doesn’t mean it doesn’t matter. If core inflation gets above 2% for a sustained period, it will affect interest rate decisions. 

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