US: Energy to have a drag effect on July and August CPI prints

July inflation, which will be announced tomorrow, is expected to decline from the 9.1% reading in June. But there is a lot of uncertainty about how quickly prices will slow down through 2023. While economist expectations point to a decline in annual inflation to 8.7% in July, there are several indicators that show that future inflation expectations are gathered in a wide range.

There are those who expect inflation in the US to fall very quickly, or to remain stubbornly high. Future period expectations in the Bloomberg terminal point to much wider ranges as the maturity progresses. For example; The forecast range for 1Q23 is 3.5% to 8%, with the median 5.8%. Inflation expectation for 2Q23 is between 1.8% and 7.7%, median forecast is 3.9%. The importance of these periods comes from the fact that they coincide with the expectation that the Fed will likely see a peak in rate hikes and perhaps begin to cut rates. However, a CPI that will remain at 7% will make it difficult for the Fed to handle interest rates.

The July CPI report will show milder inflation compared to June, but this will not provide complete relief for the Fed, nor will it sharply change its interest rate views. The fact that productivity growth is likely to be negative again in 2Q22 and the indicators revealing that wage growth has accelerated again in the last three months cause a surge in the service and wage channel, which is the type of inflation that the US is struggling with. For example, rents will keep service prices high. The June report showed the fastest increase in rents since April 1986, at 0.8% monthly. This demonstrates that the core CPI will remain high even as the headline declines, and has the potential to continue that concept in the coming year. Estimates for core inflation point to an acceleration to 6.1% year-on-year from the previous 5.9%. Further increases are also likely in the coming months, driven by the service and fee impacts we have mentioned. As the headline slows, core growth will gain momentum and bring the two inflation indicators closer together.

US CPI and its sub-items… Source: Bloomberg

Here are the positive signs about inflation: Gasoline prices fell. Pump prices decreased by about 7.5% in July. WTI, which has moved below $90, will help greatly cool the CPI increase. The current situation in oil and copper prices may have a positive impact on July and August inflation. The decrease in transportation costs may also positively affect some travel items, especially airline tickets. PPI inflation also seems to have peaked, while import prices provided some disinflationary effect through the strong dollar. Moderation in demand for goods and increased inventories at some retailers could mean prices of core goods rise at a softer clip than the 0.8% rise in June.

Long-term inflation expectations, on the other hand, are being pulled down as seen in swaps and consumer surveys. The decline in these expectations is in line with the expectation that the Fed’s tightening policy will work. If we list the factors that will cause inflation to fall in the headline sense; further decline in oil, reduction in supply chain stress, loss of momentum in services and wage inflation that gaining momentum and taking the driver’s seat. A weakening CPI trend needs to be confirmed by all these indicators.

If we take it in general; The US economy is dominated by services, and hot wage data will ultimately be the most important determinant of inflation at large. As such, the Fed now needs to do more to cool wage growth, which will mean it doesn’t back down from rate hikes. The central bank is still far from “fulfilling its duty” and is still far from the 2% inflation target. If the CPI continues to rise at a solid clip along with a solid labor market, it is very likely that policymakers will agree on another 75 basis point rate increase in September. Our baseline scenario is that the Fed’s anticipated rate hike path will not be affected much by the available data.

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