The latest US CPI report confirms what markets had assumed earlier in the week following the decline in the Manheim used car auction prices for June.
That is, core inflation pressures in the US are cooling considerably, with most of the inflationary impulse now stemming from housing specifically. In combination with last week’s release of June’s payrolls data, which showed signs that labour demand is cooling and should soon weigh on wage pressures, today’s softer core inflation release reinforces our base case and the market’s initial read on the Fed’s last rate decision that the US central bank will only be able to hike one further time this cycle. Markets have quickly adjusted to this reality, with the probability of a follow-up November hike falling 10pp to 25% and the US 2-year tumbling a further 10bps to 4.755%; a far stretch from the 5.12% peak reached earlier this month.
The response in US Treasuries to today’s inflation report resulted in the dollar extending its post-payrolls decline, with losses continuing to be most visible against currencies that are deeply undervalued and sensitive to US yields (NOK, SEK, JPY).
As has been the case for much of this year, participation in chasing the dollar lower has considerably outstripped the level of engagement when the broad dollar retraces losses. Given this underlying bias in markets and the confirmatory data over the past week, the Fed may have a difficult time pushing back on an effective loosening in financial conditions in its communications this week before it enters its blackout period ahead of its July 26th meeting. As a result, we expect the recent decline in the dollar to consolidate at a bare minimum this week.
The broad dollar index follows yields lower as it falls towards its year-to-date low
Inflation pressures fell across all key measures, with just shelter inflation showing inertia
US CPI inflation fell to 3.0% year-on-year in June, its lowest reading on a headline basis since March 2021. The headline number fell by a full percentage point, much of it thanks to energy, which fell 16.7% YoY due to base effects as the surge in energy prices a year ago dropped out of the calculation. Similar optimism was shared within the core measure, which similarly fell but by half the amount of the headline measure, from 5.3% to 4.8% YoY, printing 0.2pp below expectations in doing so. However, due to considerable base effects, the emphasis has long shifted from annual rates to sequential measures, whether that be 3-month annualised rates or standard month-on-month measures, and more specifically measures of underlying inflation pressures.
On that topic, the 3mma annualised rate of core goods inflation fell from 5.3% to 4.3% YoY with the same measure for services falling from 5.9% to 4.9%.
For the Fed, who have long prioritised core services less housing, their supercore measure has fallen from 3.1% to 1.4%, highlighting just how significant the effect of housing inflation is in core services. The softening in core inflation momentum was shared within the monthly data too, with core measure falling from 0.4% to 0.2% MoM. More importantly for the Fed and financial markets, which have recently adjusted their expectations lower for core inflation, the unrounded figure was even softer at 0.158%.
The Fed’s measure of supercore inflation falls off a cliff and undercuts the Fed’s guidance of two further hikes in doing so
Shelter accounts for nearly three quarters of the monthly increase to June CPI
As noted, shelter costs are still the main source of inflation, accounting for nearly a third of the CPI basket, rising 7.8% YoY. In June, shelter prices rose by 0.4% MoM, doubling the monthly readings on all items and core. While perhaps counterintuitive, this is good news. The Federal Reserve is acutely aware that the BLS’s shelter measure lags real time changes in rents by 12 to 18 months, and alternative data from Zillow and CoStar suggest that new rents growth has nearly come to a standstill. It is for this reason that the Federal Reserve is now largely ignoring the shelter component.
Vehicle prices have also resumed their decline
Vehicle prices are no longer an issue either following a surge in used cars over the second quarter. On a sequential basis, new vehicle prices were unchanged and used vehicles saw a 0.5% decline in June. Auto dealers report that with the chip shortage having ended, production is now back to normal, and growing inventories are putting downward pressure on prices for new cars too.
The Manheim measure of used car prices suggests further core goods disinflation is likely
Seasonal residuality is also playing a role
While normalised energy prices drove the year-on-year decline in inflation, the single biggest contributor to softer prices in June came from airfares. Airlines are now charging -18.9% less for a flight than a year ago, and slashed their prices by -8.1% in June alone. In broader context, however, prices are still reversing the post-pandemic reopening boom, with NSA prices still 5.2% higher than their average across 2019. This suggests that airfares can continue to mean-revert over the next few months, but most of the reversal is already done.
Simon Harvey, Head of FX Analysis
Jay Zhao-Murray, FX Market Analyst