Challenges Remain Despite Significant Progress in US Inflation

Headline inflation has reduced to a fraction of its peak, yet the contribution from shelter alone exceeds the Federal Open Market Committee’s (FOMC) annual target of 2.0%. In June, both headline and core Consumer Price Index (CPI) outcomes fell short of expectations at 0.2%, resulting in respective annual rates of 3.0% and 4.8%. These figures are significantly lower than their 2022 peaks of 9.1% and 6.6% respectively.

Evidence suggests a widespread deceleration in price pressures. Inflation for ‘food at home’ has slowed from 12.5% last July to 2.5%, while ‘food away from home’ has eased from 10.8% in October to 6.3%. Goods excluding energy and food have also seen inflation rates that are only a fraction of their 2021 peak rate, standing at 2.6% compared to 13.9%.

However, some sectors, including housing, continue to face an imbalance between demand and supply. The shelter component of the CPI, primarily determined by rents, has slowed from an average reading of 0.7% through the first quarter to 0.5% in the second quarter. This still equates to a 6% annualised pace for Q2, twice the average pace dating back to 1994. Given its 35% weight in the headline CPI, shelter contributes 2.1 percentage points to annualised inflation. For core inflation, the contribution is even larger at 2.6 percentage points due to shelter’s weight within the core being 43.5%.

The potential for shelter to create at or above target outcomes for inflation if current rates of rent inflation persist is a critical point. The expectation is that it will follow the market rent measures down through the remainder of the year to a still above average 4.5% annualised pace at December, allowing headline inflation to ease to 2.0% annualised. However, there are clear risks to the upside.

The Federal Reserve’s July Beige Book was constructive for the outlook. Economic activity was reported to have “increased slightly since May”, with employment growth being “modest”. Most significant for inflation is that labour market turnover rates appear to be returning to pre-pandemic norms and wage increases are returning to or nearing pre-pandemic levels.

By year-end, six-month annualised inflation is anticipated to be at 2.0%yr, albeit with the risk of a higher pulse if the shelter component shows greater persistence. On an annual basis, this equates to a 2.6%yr annual rate against the FOMC’s 3.2%yr expectation as per their June forecasts.

By late 2023, the prime risk for 2024 and 2025 is that shelter inflation is stronger than currently forecast, leaving little room for inflation elsewhere in the consumer basket. It is expected that the FOMC will become more focused on the risks to activity through the second half of 2023, having completed the tightening cycle in July with a 25bp hike to 5.375%. The first cut is most likely to occur in March 2024, with a 25bp reduction. Rate cuts are then expected to continue at 50bps per quarter through Q2 2024 to Q2 2025, leaving the fed funds rate at 2.625% mid-2025.