U.S. core consumer price inflation (CPI) was firmer than expected in June, with a 0.3% rise that boosted the year-over-year rate to 2.1%. The timing of the strong print is somewhat awkward for Federal Reserve officials who have signaled a willingness to cut interest rates in July, and for Chairman Jerome Powell, who emphasized the absence of inflationary pressures during his semiannual testimony to Congress this week.
However, it’s worth noting that June inflation may have been boosted by the recent increase in import tariffs, while inflationary pressures from rising wages and tight labor markets remain notably subdued. Unit labor costs – which adjust wages for productivity gains, and are therefore a better measure of the likely pass-through of higher wage inflation to consumers – have declined for the past two quarters.
Overall, the latest CPI print didn’t materially change our outlook for moderate but stable core CPI inflation a little above 2% for 2019. And given weaker trends in U.S. real business investment, exports, and manufacturing growth, along with the recent unsustainable build in inventories and rising business uncertainty, we think both a 25- and a 50-basis-point (bp) cut to the federal funds rate are on the table at the upcoming July FOMC (Federal Open Market Committee) meeting.
Core goods subject to increased Chinese import tariffs see strong gains
Looking at the details of the June CPI report, firmer price gains were witnessed in core retail goods, used cars, and shelter prices.
Core retail goods prices (excluding autos and medical) increased 0.3% month over month, with more notable gains in categories that include Chinese products subject to higher import tariffs: Furniture and bedding, small appliances, and recreational vehicles were notably strong.
Relevant analysis suggests that so far, U.S. corporate margins have absorbed the brunt of the costs arising from the initial increase in tariffs on various Chinese imports last September. However, with the one-time earnings adjustment from the Tax Cuts and Jobs Act’s (TCJA) lower corporate tax rates largely complete, corporations may now be less willing to absorb the additional costs from the further tariff hikes implemented in mid-June. Price gains in apparel, which has not yet been hit by increased import duties, were also strong.
Used car prices bounce and rents continue to firm
Outside of the core retail categories, used car prices rebounded strongly (+1.6%) in June after four consecutive months of large declines. Tighter auto lending standards helped cool the used car market earlier this year, but used car prices at wholesale auctions, which tend to lead consumer prices by one or two months, have stabilized and point to a modest rebound in used car inflation in the third quarter.
Monthly price gains in rents and owner’s equivalent rents were also again firm. However, we had expected some firming resulting from low economywide shelter vacancy rates and the lagged effects of higher mortgage interest rates in 2017 and 2018, which reduced the affordability of owning a home.
Thursday’s firmer-than-expected CPI print is awkward for the Fed, which has strongly signaled it will cut interest rates in July. However, the June print did not prompt a significant change in PIMCO’s near-term outlook for core CPI inflation (or personal consumption expenditures (PCE) inflation, the Fed’s preferred measure). Furthermore, some of the strength was likely related to business pass-through of higher import tariffs, which the Fed would likely look past due to the negative near-term implications for real growth. Overall, we continue to expect the Fed will cut the policy rate at its July meeting, with both a 25- and 50-bp cut up for discussion.