US inflationary pressures continue to weaken in May

Encouraging CPI figures from the US, showing inflationary pressures to be back on an easing path, with both the annual and core rates coming in lower than expected. This is the third consecutive month that both the annual core and headline rates have fallen and increasingly suggests that Powell was right when he referred to the stronger data seen in Q1 as “bumps in the road”. Indeed, the annual core rate has now fallen back to its lowest level since April 2021. The market has responded accordingly by now fully pricing in a first rate cut by November, although if we get a couple more reports similar to today’s then the FOMC may have enough confidence to cut rates as soon as September’s meeting.

Prices for core services ex-rents were unchanged on the month, a big improvement on the average 0.6% monthly increase seen so far this year, although much of this improved performance is explained by a 3.6% fall in airline fares – which are erratic – and an unexpected 0.1% fall in car insurance prices, a huge reversal from the average 1.7% monthly increases that have been seen so far this year. And it was a similar story seen with core goods prices, which were also unchanged and suggesting that the 0.2% monthly increase seen in April was just noise rather than the start of a renewed upwards trend. The numbers certainly give Powell the ammunition he needs at today's FOMC press conference to say that the Fed is winning the battle with inflation; although he will likely also stress that a couple more similar prints will be needed before the Fed will be confident enough to cut rates, particularly given the strong labour market report we had last week.

Looking forward, the outlook for prices is looking increasingly comfortable, with wages growth - as indicated by a falling quits rate – looking set to fall back to pre-covid levels and which will, in turn, act as a drag on both services inflation and shelter costs. And at the same time, the slowdown in the strength of consumption being seen will apply downwards pressure on retail margins, which still remain at elevated levels post-covid, while normalised supply chains and benign global food and energy price inflation have further removed what were previously key drivers of upwards pressure on prices. But the current Fed is very risk averse, and it will not be willing to counter cutting interest rates until it is absolutely certain that CPI is definitively moving back to target, and that includes being sure that inflationary threats such as wages growth are similarly under control.

However, what really matters for the Fed are the PCE numbers, and those have been disappointing so far this year, the average monthly YTD figure pointing to an annual rate of growth of close to 4% still. Therefore, despite today's better CPI prints, we could yet see tonight's Fed meeting scale back the number of interest rate cuts expected this year from three to two (possibly even just one), which might just disappoint the markets a little.