Thoughts

May 12, 2023 | 13:37

U.S. Inflation: Painstaking Progress

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

The April CPI report drew more than the usual amount of attention as it captured the first full year of aggressive monetary tightening and the first month of regional bank stress. The report largely met expectations of some further easing in headline and core inflation to 4.9% and 5.5%, respectively. Markets took some comfort from hints of cooling in the over-heated services sector. Notably, high-flying airfares and hotel rates fell sharply and auto rental costs extended a downtrend, suggesting some let up in pent-up travel demand, perhaps in response to high prices. Excluding energy and rent, services prices rose slightly, slicing the yearly rate to 5.1%, versus a peak of 6.5% last fall. Even adding in rising restaurant prices—to make this metric more comparable to Powell’s ‘supercore’ PCE price guide—yielded a moderate 0.2% advance, the smallest in nine months and chopping the yearly rate to 5.6%. Softer producer prices flag some further ebbing in services inflation at the consumer level.

Goods inflation largely remains subdued. The core commodities CPI was flat in April after excluding a (likely temporary) spike in used vehicle prices. There’s little sign of pressure from the weaker greenback, as household furnishing costs fell for the first time in more than two years, led by a record slide in appliances. Import prices, excluding fuels, held steady in April after falling in March, and are down 1.9% in the past year. Milder goods inflation reflects the normalizing of supply chains and softening in resource prices—notably energy and agriculture. The latter explains some recent relief in grocery bills. All measures of inflation—headline, core, supercore—should fall further this summer due to friendly base effects.

The steady progress on inflation allowed the Fed to signal a potential rate pause last week. It will use this timeout to recalibrate where inflation may settle as the economy adjusts to past rate increases and tighter lending conditions stemming from the regional bank stress. Alas, it’s rare for inflation to return to previous lows without some increase in the jobless rate. Yet, this rate is lower today than when the Fed started tightening. That likely explains why wage gains, though moderating, remain heated, and why some companies are readily passing price increases onto customers. The latter is aggravated by excess household savings and some lingering revenge spending.

While inflation should remain in retreat, we suspect it will still have a 3-handle at the end of the year, before settling at the 2% target next summer. But this benign path assumes the economy will slump for a couple of quarters and the unemployment rate will increase by just over one percentage point. While wages aren’t driving inflation higher, they are delaying its return to the target. A recent backup in jobless claims to more normal levels suggests the labour market is starting to loosen. But the FOMC likely won’t declare mission accomplished until it sees some meaningful rise in the jobless rate, harking back to Powell’s remark that there is “no painless way to restore price stability”. This may not require higher policy rates, but it does cast serious doubt on lower rates this year.