CPI resumes disinflationary trend in April amid weakened retail sales

REAL ECONOMY BLOG | May 15, 2024

Authored by RSM US LLP

The drop in April’s consumer price index was a much-needed step in the right direction in the Federal Reserve’s effort to tame inflation and provided hope for potential rate cuts this year.

Retail sales, in another key report released on Wednesday, indicated a much weaker April, explaining the extended drop in goods prices.

Lower inflation and spending should mean more relief for the Federal Reserve as it tries to bring inflation down to its 2% target. But the data is likely insufficient for the Fed to adjust its policy rate in June or July, given the rebound in inflation that took place in the first quarter.

Barring any unexpected shocks, September is the earliest we could expect a rate cut after the second quarter and some third-quarter data is released. Market bets suggest a September cut is a coin flip.

Still, we think the market will begin to temper its overreaction to the recent rebound in inflation, starting with the bond market.

It is too early to predict whether the next market expectation reset will be as significant as the one in January, which took place after six months of good inflation data, or the one last month, which occurred after three months of bad inflation data.

Overall CPI inflation rose by 0.3% in April, while core inflation—which excludes food and energy—also rose by 0.3%, according to the Labor Department. This helped bring the year-over-year headline inflation down to 3.4% and core inflation to 3.6%. Retail sales were unchanged, with the control group—which feeds into GDP calculations—falling by 0.3%, a sharp drop from a 1.0% increase in March, according to the Commerce Department.

In our view, the economic fundamentals remain encouraging for further disinflation, even though the path to price stability has been bumpy. Rates are highly restrictive, continuing to soften overall demand, especially in housing and automobiles, two of the top categories that contributed to the sharp spike in inflation over the last three years.

Shelter rent grew by 0.4% for the month, with owners’ equivalent rent—the largest component of total inflation—increasing by 0.4% from a month ago. That is unchanged over the past three months.

But real-time rent and housing data suggest that the rent component in the inflation report—which lags real-time rent prices by 15 to 18 months—should show a material decline in the next couple of quarters.

The Fed, especially its chairman, Jerome Powell, has signaled a similar view on the continuation of disinflation, led by housing disinflation in the months ahead. The central issue for the Fed is when these disinflation signs will appear.

Excluding housing, transportation services, led by motor vehicle insurance, contributes about 3 percentage points to the more than 4% year-over-year increase in the super-core metric used by the Fed to gauge underlying inflation.

The weight of motor vehicle insurance in the personal consumption expenditures inflation report is four times lower than in the consumer price index report, which is one reason why PCE inflation has been running below the CPI.

Given Wednesday’s CPI data and the producer price index data released on Tuesday, we should expect some softening in the PCE data when it is released at the end of the month. The Fed uses PCE data as it primary gauge of inflation.

This means the 12-month PCE inflation numbers would most likely remain between 2.5% and 3%, which is tolerable without sacrificing employment growth in our opinion.

We have long argued that in the post-pandemic era, the Fed’s inflation target should be higher than before. The Fed’s determination to bring inflation down to 2% reflects the difference between what we think the Fed should do versus what it is likely to do.

The slowdown in retail sales does not suggest that American consumers are starting the second quarter on a strong note, contrary to the Atlanta Fed’s prediction of 4.2% gross domestic product growth in the second quarter.

While household balance sheets remain solid, many are relying on their paychecks and sustained wage increases to support their spending as excess savings built up during the pandemic dwindle.

By adjusting its inflation target and cutting rates sooner, the Fed could further maintain a strong labor market, fueling spending while anchoring inflation between 2.5% and 3%.