Today's US CPI numbers cloud the outlook for US monetary policy

Today’s CPI numbers from the US have very much reinforced the Fed’s message of a couple of weeks ago, ie that a pause in the current interest rate hiking cycle can be expected at tomorrow’s FOMC meeting. Both the core and headline monthly readings printed in line with expectations, the headline rate in particular notable for its fall from 0.4% to just 0.1%. On an annual basis, headline CPI fell by a large 0.9% to 4.0%, to leave prices now increasing at their slowest pace since March 2021. The annual core rate also contributed to the rosier picture, with a more modest 0.2% fall to 5.3%. On the back of these numbers, expectations of a hike being delivered by the FOMC tomorrow have fallen back to just over 10%, leaving them largely in-tune with the Fed’s message to expect a pause. But interestingly, market expectations of an interest rate rise being delivered at the July FOMC meeting remain high, falling by around only 10% from approximately 80% to an expected 70% chance. The suggestion is that there are two issues at play here.

Firstly, justification for the Fed’s ‘pause’ position can be seen in a break-down of the numbers. This shows that shelter costs – ie rents – provided the biggest contribution to the core reading today, rising by 0.5% for the third month in a row and following gains averaging around 0.7% over the previous six months. This is key as rents account for some 41% of core CPI. But the key point is that they are moving lower. Real time data is showing rents have largely given up all their post-covid gains and, as we start to see these reductions continue to feed through into the CPI numbers, so the upwards push from shelter costs on CPI should steadily diminish. Second, after shelter costs, the next biggest contributor to CPI was used car prices, which rose strongly following the unseasonably warm winter weather which allowed buyers to venture out to car lots during the winter months when normally colder and more snowy weather would keep them indoors. This upwards pressure will reverse over the summer. Given that rents and used vehicle prices taken together accounted for some 80% of May’s increase in the core monthly figure, the outlook going forward suggests core CPI will track the headline number and print lower.

However, what is probably of more concern to the market is that the 0.4% monthly core reading is incompatible with a CPI target of 2%, suggesting as it does an annualised rate of some 4.8%. And the actual annual core rate remains elevated even above this level at 5.3%. Based on these numbers, a further 25bps increase in interest rates could easily be justified by the ‘hawks’ on the FOMC. Further, the Fed has consistently said that for the current interest rate hiking cycle to be ended, a consistent run of lower CPI numbers is needed. This is an understandable position given the performance of the CPI numbers over the past couple of years, where a lower print one month has typically been followed by higher prints in the months immediately following. So by this measure, the tightening cycle appears far from over.

So where does this leave us? The signalling given by the Fed, that the market could expect a pause in the current hiking cycle for this month, appears consistent with today’s headline CPI numbers. But we know that the Fed pays little attention to the headline numbers, choosing instead to focus on the core CPI numbers, in particular the core CPI Services number ex rents ex energy, numbers which would suggest another 25bps rise could easily be justified. It is a confusing picture, and is why the market continues to attach such a high probability to the chances of a further interest rate rise being delivered at the July FOMC meeting. Overall, the Fed’s signalling of a June pause has simply created uncertainty about the immediate direction of US monetary policy, leaving the market even more reliant on data releases over the next six weeks or so for determining its expected outcome of July’s FOMC meeting: we can probably expect some sizeable repricing of what is expected between now and then.