In a much-needed respite for consumers and the economy, the latest U.S. inflation data showed pricing pressures eased significantly in May. The Consumer Price Index (CPI) remained flat month-over-month and rose just 3.3% annually, according to the Bureau of Labor Statistics report released Wednesday. Both measures came in below economist expectations, marking the lowest monthly headline CPI reading since July 2022.
The lower-than-expected inflation numbers were driven primarily by a decline in energy costs, led by a 3.6% monthly drop in gasoline prices. The overall energy index fell 2% from April to May after rising 1.1% the previous month. On an annual basis, energy prices climbed 3.7%.
Stripping out the volatile food and energy categories, so-called core CPI increased just 0.2% from April, the smallest monthly rise since June 2023. The annual core inflation rate ticked down to 3.4%, moderating from the prior month’s 3.5% gain.
The cooling inflation data arrives at a pivotal time for the Federal Reserve as policymakers weigh their next policy move. Central bank officials have repeatedly stressed their commitment to bringing inflation back down to the 2% target, even at the risk of slower economic growth. The latest CPI print strengthens the case for interest rate cuts in the coming months.
Financial markets reacted positively to the encouraging inflation signals, with the 10-year Treasury yield falling around 12 basis points as traders priced in higher odds of the Fed starting to cut rates as soon as September. According to futures pricing, markets now see a 69% chance of a rate cut at the central bank’s September meeting, up sharply from 53% before the CPI release.
While the overall inflation trajectory is encouraging, some underlying price pressures remain stubbornly high. The shelter index, which includes rents and owners’ equivalent rent, rose 0.4% on the month and is up a stubbornly high 5.4% from a year ago. Persistent shelter inflation has been one of the biggest drivers of elevated core inflation readings over the past year.
Economists expect the housing components of inflation to eventually moderate given the recent rise in rental vacancy rates and slowing home price appreciation. However, the timing of that slowdown remains highly uncertain, keeping a key pillar of inflation risk intact for the time being.
Beyond shelter costs, other indexes that posted monthly increases included medical care services, used vehicle prices, and tuition costs for higher education. In contrast, airline fares, prices for new cars and trucks, communication services fees, recreation expenses and apparel prices all declined from April to May.
Despite the positive inflation signals from the latest CPI report, Federal Reserve officials have cautioned that the path back to 2% price stability will likely encounter bumps along the way. Last week’s stronger-than-expected jobs report reinforced the central bank’s hawkish policy stance, with the labor market adding 272,000 positions in May versus expectations for 180,000. Wage growth also remained elevated at 4.1% annually.
With both low inflation and low unemployment now seemingly achievable, the Federal Reserve will need to carefully navigate its policy path to engineer a so-called “soft landing” without tipping the economy into recession. Many economists expect at least a couple of 25 basis point rate cuts by early 2024 if inflation continues cooling as expected.
For investors, the latest CPI data provides a much-needed burst of optimism into markets that have been weighed down by persistent inflation fears and looming recession risks over the past year. Lower consumer prices should provide some relief for corporate profit margins while also supporting spending among cost-conscious households. However, the key question is whether this downshift in inflation proves durable or merely a temporary reprieve.
The Fed’s ability to deftly manage the competing forces of lowering inflation while sustaining economic growth will be critical for shaping the trajectory of investment portfolios in the months ahead. Keep a close eye on forward inflation indicators like consumer expectations, global supply dynamics, and wage trends to gauge whether this cooling phase proves lasting or short-lived. The high-stakes inflation battle is far from over.
