While the Fed will likely succumb to cutting pressure in September, investors should realize that the trajectory for interest rates may not be as aggressively dovish as recent data suggest.
July CPI inflation defied consensus in two different directions: headline surprised to the downside, while core surprised higher. This relative softness in the headline print is important: the Fed, targeting headline inflation as part of its “dual mandate”, can add this soft surprise to the recent slowdown in payroll gains and paint a compelling picture for a rate cut in September.
The details of the report, however, show a muddier picture, one where tariff-related price pressure is building, and services costs are firming more than expected.
- Softer headline but stronger core on falling energy prices: Headline CPI rose 0.2% on the month (2.7% on the year), flat with June’s reading. Food prices were flat, but energy prices fell over 1%, driven by a sharp decline in gasoline prices. Without these commodities, core prices rose 3.1% on the year – the hottest print since February.
- Core goods price changes were lumpy: Core goods prices rose at a pace that matched last month (0.2%), but recently-cool spots warmed while recently-warm spots cooled. New vehicle prices were flat as dealers continued to offload inventory but used vehicle prices rose for the first time since February; and appliance prices fell after spiking last month.
- Core services prices surprisingly firm: Core services inflation accelerated on the month relative to June. Shelter inflation – long a thorn in the side of the CPI calculation – persisted at previous levels, and airfare prices saw a meaningful 4% gain after five consecutive months of declines.
Warmth in certain core goods components is easy to explain away: tariffs are taking their toll on import prices. Softness in other core goods components is similarly easy to explain: inventory build in the first quarter allowed certain businesses to front-run tariffs, and others might be absorbing tariffs through margin compression, suggesting that prices will eventually rise once these forces fade.
Much more puzzling is the core services dynamic. Undoubtedly a seasonal component has encouraged part of it – end-of-summer whatever-the-cost travel demands have helped to reinvigorate airline pricing power (TSA checkpoints saw almost 5% more travelers relative to the prior month). However, they don’t explain everything: recreation prices were up; and services as disparate as haircuts to laundry to dentist visits saw upward price pressure, too.
This strength in services could perhaps just be the “calm before the storm” – consumers spending while tariff-related inflation is subdued; but it might also reflect underlying tailwinds – like record high equity prices, fading policy uncertainty and recently-passed fiscal stimulus.
The net result, as with many recent data prints, is there is more to the inflationary story than meets the eye. While the Fed will likely succumb to cutting pressure in September, investors should realize that the trajectory for interest rates may not be as aggressively dovish as recent data suggest.