Fed Will Find Inflation Residue Surprisingly Sticky

When I was a kid, a skunk infiltrated my family’s basement and discharged its vile-smelling spray, briefly making the property unlivable. Once we called animal control and conducted a deep clean, the situation quickly transitioned from acute crisis to nuisance: The home was livable again, but the smell proved difficult to fully eradicate from carpeting and furniture.

That’s roughly where Federal Reserve policymakers find themselves in the fight against inflation. There’s a persistent and slightly foul whiff of inflation in America, and they can metaphorically open a few more windows and buy more scented candles or, alternatively, they can cave into the hawks, raze the house (in this case the US economy) and rebuild from scratch. Personally, I’d vote for the candles.

The US core consumer price index — which excludes volatile food and energy prices — rose 0.4% in May from a month earlier, extending its streak of moderately bad inflation readings of roughly that size to six. On a three-month annualized basis, core CPI has been around 5% since November. That’s not awful, but it’s definitely not good, which leads to a lot of lively debate about how to proceed.

For the time being, Fed policymakers are almost certain to stand pat and keep the fed funds rate at a target of 5% to 5.25% when they conclude their meeting on Wednesday. That’s the move that influential members of the committee telegraphed, and there was nothing shocking enough in Tuesday’s report to change their minds. But subsequent policymaking remains an open question.

After Tuesday’s numbers, here are the optimistic and pessimistic takes on the US’s persistent core inflation.

Optimistic Interpretation

For positive thinkers, there have clearly been some encouraging developments in recent months, and the most obvious one starts at the top.

Economists and policymakers tend to pay short shrift to overall headline inflation. As the story goes, the month-to-month volatility in food and energy prices can make it hard to decipher the underlying trend, so the Bureau of Labor Statistics created a core index that strips out all of that noise.

While that makes sense, headline inflation remains the truest representation of what consumers experience — and it has improved meaningfully in the past several months, no matter how you measure it. On a three-month annualized basis, headline inflation just cooled to 2.2%, the lowest since November 2020. On a year-over-year basis, overall CPI dipped to 4%, the lowest since March 2021, and base effects suggest it’s heading even lower next month.

Lower energy price trends have helped, but they’re far from the only factor. As of May, just 56.4% of CPI components by weight are inflating at a pace greater than 4% annualized, the lowest share since September 2021. Those numbers are also clearly still elevated (“normal” would be about 20% of the index), but the proportion is trending in the right direction.

The numbers of categories with extreme inflation are diminishing every month. Only about 15% of the index is inflating by a rate that’s more than one standard deviation above its historical mean.

So what’s causing the trouble?

Lately, a lot of it has been coming from used cars and trucks. They alone contributed 0.12 percentage point to May’s month-on-month inflation, and wholesale and other market data suggest they could soon flip from a big driver of the top-line number to an overall drag. Here’s a great chart with data courtesy of Inflation Insights LLC President Omair Sharif, who thinks used cars could become a significant drag in June and July CPI. The graphic shows wholesale prices measured by Manheim, JD Power and Black Book, and together, they suggest that declines in the CPI used-car category are coming:

Negative Interpretation

The pessimistic view is that we’ve been making excuses like that (“it’s just energy”; “it’s just automobiles”; “it’s just housing”) for what seems like the duration of this two-and-a-half-year inflationary episode. But inflation just keeps bounding from one category to the next and then coming back around again. For hawks, it’s unclear when the economy will ever get off this merry-go-round without the Fed taking policy rates meaningfully higher to put unquestionable restraint on business and consumer spending. They would also argue, I suspect, that policymakers would have been better served by trusting the classic signal from core inflation — not creating bespoke metrics that fit their narrative.If you do so, it’s pretty clear that underlying inflation is simply moving sideways:

Even the pessimists have to acknowledge, at this point, that inflation probably won’t get much worse if the Fed holds interest rates at current levels. But basic logic would suggest that the American public is becoming dangerously used to this state of affairs. The longer that inflation sits around 5%, the harder it may ultimately be to return it to the 2% anchor. The available measures of long-term inflation expectations suggests we’re not there yet, but it’s conceivable that the nation could get there in the second half of the year, especially if oil prices climb. Saudi Arabia’s energy minister, Prince Abdulaziz bin Salman, announced unilateral supply cuts earlier this month, giving new fodder to forecasters who have been warning about lower inventories in the second half.

I tend to think that Fed policymakers can afford to play the waiting game, and that’s almost certainly what they plan to do when they announce their policy decision on Wednesday.

Their July decision, of course, is another matter, and the burden of proof will be on the doves to prove that the situation is undoubtedly improving. Otherwise, the hawks are likely to get at least one more rate increase in July — and if even that doesn’t start to eviscerate the foul smell of inflation in the US economy, then I fear that they may just try to burn the house down.