CPI made less progress than markets had hoped, falling from 8.5% to only 8.3% (where ~8.1% was expected). Core CPI was particularly disappointing, actually rising from 5.9% to 6.3%, narrowly below the peak of 6.5% in March.
Like going from an “F” to a “C” grade, it is moving in the right direction, but nothing to hang on the refrigerator just yet. We believe this will deepen the Fed’s resolve in its continued hiking cycle, meaning credit investors should consider careful security selection to ride out inevitable volatility.
Goods inflation is making way for services inflation
As with last month, energy CPI continued its reversal, underlying the continued improvement in other “flexible” goods categories such as used cars and airfares.
However, it is increasingly clear that this is not sufficient to bring inflation swiftly back to the Fed’s target. This is because the “sticky” sectors are now picking up the baton (as we have long highlighted). Bringing these sectors down will be a long process that will require more meaningful tightening.
Table 1: The flexible sectors are now reversing, but the sticky sectors are still rising1
|Health services||Owners' Equivalent Rent||Education and Commuication||Airfare||Used Cars||Apparel||Food||Energy|
|12 month Average||0.5%||0.5%||0.1%||2.7%||0.6%||0.4%||0.9%||1.9%|
Energy prices continue to reverse
The Fed will no doubt find comfort from the dramatic decline in energy prices. In May, gasoline prices saw their largest 3-month rise on record, while the latest reading shows the second-largest fall (Figure 1).
Figure 1: Gasoline prices are falling by close to the fastest on record2
Importantly, as gasoline prices are so widely felt by the consumer, this will also ease pressure on disposable income, making a soft landing more achievable. Based on current oil market forwards, gasoline CPI will start falling on an annualized basis by Q1, after having added three percentage points to inflation earlier this summer.
Supply chains are also disentangling
Several household durable categories are starting to recover with improving supply chains. The most noticeable is used car prices, which had risen by 40% at their peak (adding over 1.2 percentage points to CPI) but are now down over 10% from that high (Figure 2), potentially offering a further disinflationary impulse over the coming months.
Figure 2: Used cars are now falling from their peak3
The sticky CPI sectors are the Fed's "final boss"
As we have consistently projected, inflation pressures are shifting from (flexible) goods categories to (sticky) services categories.
Our “big three” services categories continue to run hot and were, for the first time this cycle, the largest outright drivers of this month’s upside surprise in CPI (Figure 3).
Figure 3: The sticky inflation sectors are now running hotter than flexible categories4
Owners’ equivalent rent is now up 6.3% year-on-year. Meanwhile, the 0.8% month-on-month rise in medical services CPI equals its 30-year high. We feel these categories need to run closer to 3% to 3.5% to make the Fed’s target achievable. However, as pricing is typically refreshed on an annual basis for rents and healthcare, we expect inflation in these categories to remain persistent.
There are glimmers of hope, however, that the worst may at least be over. For instance, the rental vacancy rate is starting to rise from extremely tight levels, most dramatically in cities like Phoenix and Miami, which saw the fastest rental increases during the pandemic, but are now underperforming the legacy urban centers like New York and San Francisco (Figure 4).
Figure 4: There could be hope for the rental market starting to cool5
Peak CPI, but we face a slow descent
The persistent nature of services inflation will be a headache for the Federal Reserve for some time and will make meeting the 2% inflation target difficult to achieve on a sustained basis. We see sticky sectors keeping headline CPI around ~6% at year-end.
This will further embolden the Fed. A 75bp rate hike is now highly likely at its meeting next week. We still expect the terminal rate will be between 4% and 4.5% (from 2.5% now). We do not expect to see a cutting cycle before 2024.
Rate hikes and continued quantitative tightening, coupled with ebbs and flows in geopolitical headlines, almost guarantee ongoing volatility. In our view, this makes careful security and sector selection particularly important in credit, to help investors ride out the tightening cycle and concerns around a recession as well as participate on any upside surprises from future inflation prints or positive developments in Ukraine.