Consumer prices jumped more than expected in May, but the surge in inflation looks to be temporary and should not push the Fed to tighten policy for now.
The consumer price index rose 5% in May on a year-over-year basis, the highest since 2008, when oil prices were skyrocketing. Excluding food and energy, core CPI rose 3.8% year-over-year, the highest pace since 1992. A third of the increase was attribute to a sharp 7.3% increase in used car and truck prices.
“The pick-up in inflation is stronger than expected, but it still looks like it is in transitory categories,” said John Briggs, global head of desk strategy at NatWest Markets. “[Fed officials] can probably get away with talking about transitory.”
The Federal Reserve meets June 15 and 16. There was some market speculation that if inflation looked very hot, the central bank might move up the time frame on when it would begin to discuss cutting back its bond purchases. Many economists have been expecting the Fed to first talk about tapering bond buying at its Jackson Hole Economic Symposium in late August, before actually cutting the size of purchases in late 2021 or next year.
“There’s evidence it’s transitory because a lot of the surge in prices are for things that are just normalizing… Hotels and rental cars and used vehicles, sporting events, restaurants. Everyone is just getting back to normal so pricing is just returning to what it was pre-pandemic,” said Mark Zandi, chief economist at Moody’s Analytics. “That is transitory. That is one-off.”
However, he added that it’s too soon to say inflation won’t be more persistent than the Fed expects. “It’s premature to conclude all of this is transitory and where underlying inflation is ultimately going to land when we get through the price normalizations,” Zandi said. He expects when the surge is over, inflation will be at a higher level than it was pre-pandemic.
The Fed has said it would tolerate inflation running above its 2% target, and it would consider an average range for inflation. That means it has committed to hold off on increasing interest rates as soon as it sees inflation risks rising.
Financial markets took the surge in CPI in stride, and stocks jumped after the 8:30 a.m. ET report. The Dow gained more than 200 points, but gave up its best gains by late morning. The 10-year Treasury was slightly higher at 1.49%, after initially rising as high as 1.53%. Yields move opposite price. Fears the inflation number would push the Fed to shift policy sooner would have driven yields much higher.
The components of higher prices
“The used car component is just stunning,” said Grant Thornton chief economist Diane Swonk. “What’s kind of surprising is how low the shelter component has remained. It’s coming up from where it decelerated. There’s now the question of it picking up. We have to watch that, but I would have expected more of a hotel room increase in shelter.”
Shelter accounts for more than 30% of CPI. The shelter index rose 0.3% in May, and 2.2% over the last 12 months. The rent portion rose 0.2%, and the index for owners’ equivalent rent rose 0.3%. Lodging away from home rose just 0.4%, after jumping 7.6% in April.
Another big component, medical care, fell 0.1% after rising in the four previous months. Medical care prices rose just 0.9% over the past 12 months, the smallest increase since the period ending March 1941.
“Medical care and housing are two very large components of inflation. They’re both very sticky and a reason to think inflation will settle at a higher level but not at a level that is uncomfortable,” said Zandi. “The reason for being so sanguine is around medical care and housing.” He said the expansion of the Affordable Care Act has helped hold down medical costs.
Grant Thornton’s Swonk said she does not expect much from the Fed next week, and the inflation report does not change that.
“The remarkable resilience of the long bond, it gives the Fed the opportunity to think about tapering because financial markets are buying it as a transitory surge in inflation,” said Swonk.
Once the Fed begins talking about tapering openly, it is expected to wait several months before beginning to slow the monthly purchases of $120 billion in Treasury and mortgage securities. Once it completes the wind down many months later, the door would be open for Fed officials to raise interest rates, which is not expected by markets until 2023.
“I always expected tapering talk to begin more openly at the Jackson Hole meeting. It hasn’t changed my view. Some people thought the Fed would get closer to full employment before they did liftoff on tapering,” Swonk said.
She said some data in the CPI report dovetails with the weaker than expected jobs data. The economy created 559,000 jobs in May, about 100,000 less than expected.
“If you look at the combination of events — used car prices, insurance costs on vehicles, all of these things accelerated and now they’re rebounding. Prices at the pump, they’re up over 50% from a year ago,” Swonk said. “All of this is making it harder for workers to get to low wage jobs.”