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Reports of the latest U.S. headline inflation numbers—the overall Consumer Price Index (CPI)—have raised expectations that inflation is finally being tamed, further raising hope of less restrictive monetary policy and a soft landing for the economy. But core CPI, which factors out more volatile categories, tells a more nuanced story.
“People tend to focus on the year-over-year 3% headline CPI,” said Asawari Sathe, a Vanguard senior economist. “It’s a positive story and shows inflation going in the right direction, in line with our forecasts of core inflation falling to somewhat above 3% by year-end.”
But, she said, it’s not the end of the story. Most of the drop from previous highs was attributable to a sharp fall in fuel prices and moderating food prices. Core CPI—which excludes those categories—was at 4.8% in June, modest by recent standards but showing a widening gap with headline inflation.
“Even more telling is the widening gap with the ‘sticky’ or ‘sticky-price’ CPI, which goes further than core CPI in winnowing out volatile categories,” Sathe said. “Sticky prices are labeled as such for a reason. Not only are they more resistant to change, they better capture future expectations on broader inflation.”
Year-over-year sticky CPI, as tracked by the Federal Reserve Bank of Atlanta, was 5.8% in June, even higher than core CPI. The accompanying chart shows the reversal and widening gap between the three incarnations of CPI. While all three are going in the right direction, the core and sticky indicators may give the Fed more incentive to maintain a restrictive policy longer than some might hope.
Inflation dropped sharply, but some categories only moderated
Notes: Headline CPI is overall inflation. Core CPI excludes food and fuel. Sticky-price CPI, as tracked by the Federal Reserve Bank of Atlanta, includes only categories in which prices change infrequently, such as medical services, education, personal care services, and housing.
Sources: Vanguard, based on data from Refinitiv Datastream, Moody’s Analytics Data Buffet, the U.S. Bureau of Labor Statistics, and the Federal Reserve Bank of Atlanta, as of July 15, 2023.
Prices for shelter and transportation services moderated in June and even modestly fell for vehicles. “None of this is a surprise,” Sathe said. “Used-car auction prices were falling in previous months, and those are a leading indicator for the vehicle component of CPI. A weakening housing market that started last year is being more fully manifested in today’s numbers. And demand for summer travel is moderating.
“This may give hope for further falling prices, but education expenses and expected increases in medical insurance—driven by rising insurers’ margins last year—are due in the coming months, so core inflation overall may not recede as quickly. And, frankly, inflation can’t be reined in until we see the labor market slow down further, given the close and complex relationship between wages and inflation.”
After raising interest rates by 25 basis points on July 26, the Fed will also be looking closely at the labor market to help determine whether further rate hikes may be needed to bring core inflation back toward its 2% target. (A basis point is one-hundredth of a percentage point.)
The recent sharp drop in headline inflation does not radically change Vanguard’s outlook for the economy, Sathe said: “Inflation may continue to moderate, but it remains a concern. The Fed cutting rates is unlikely any time in the near future, and a mild recession is still likely.
“That said, the latest inflation figures do provide hopeful signs for the economy, but no one should believe the inflation fight is over.”
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