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What’s Behind the Slowdown in U.S. Inflation

Core inflation came in below expectations for October and should moderate in 2023, but likely with bumps in the road ahead.

October’s U.S. Consumer Price Index (CPI) inflation data was even softer than many observers had expected, with core inflation gaining just 0.3% month-over-month (m/m) versus consensus expectations of 0.5%. Pre-holiday retail discounting, a decline in used car prices, and a welcome easing in rental inflation were key drivers of the overall decline in CPI.

While we would caution against calling a peak in U.S. inflation, as we suspect some of the categories that were particularly weak in October will temporarily re-accelerate in the months ahead, the October data was a welcome sign that the central bank’s actions to date are starting to cool the economy. Consistent with this, October’s data likely solidifies the U.S. Federal Reserve’s resolve to slow its pace of policy rate hikes in December (see our recent blog post, “Fed Sets Up a Pause, Not a Pivot”). October’s CPI report also bolsters our confidence that the Fed will pause when rates enter a 4.5%–5% range, as we discussed in our latest Cyclical Outlook.

October inflation report details: cars, retail goods, rent, health insurance

Most categories saw softer-than-expected inflation readings. Core goods prices were down 0.4% m/m, including in subcategories such as cars and furniture that tend to be more sensitive to interest rates. Services inflation also cooled to 0.5% m/m versus 0.8% m/m in September.

Core goods prices fell following price slashing across used car dealerships. Higher inventories and subdued rental car company buying had contributed to wholesale price declines in prior months; however, it wasn’t until October that dealers more fully passed on these declines to consumers. While this is good news for overall inflation, we believe used car prices may re-accelerate in the months ahead as relatively price-insensitive demand and auto damages from Hurricane Ian temporarily boost prices before they decline once again.

Meanwhile, early holiday discounting from several major retailers contributed to flat retail goods prices overall, and notable declines across household goods (notably furniture, which tends to be sensitive to interest rates) and apparel. We had been expecting to see goods price discounts at some point after inventory-to-sales ratios recovered and as other input costs, including shipping and logistics costs, eased earlier this year. However, this is the first month that CPI data reflected outright price declines across these categories.

Turning to core services, rents and owners’ equivalent rents (OER) cooled slightly in October after a string of shockingly strong reports. Alternative data on rental listing prices and rents recorded in new leases have already shown a notable cooling over recent months, as has the broader U.S. housing market. However, given the usual lags, we don’t expect this cooling to be fully reflected in CPI-reported OER and rentals until late 1Q or early 2Q next year. Until then, we anticipate OER inflation will remain relatively resilient.

Finally, healthcare insurance prices also dropped in October, and we expect this new pace will contribute to more moderate inflation in the broader healthcare category over the next year. Note that the Bureau of Labor Statistics (or BLS, which publishes the CPI) methodology uses data that is published only once per year and with a lag. CPI had been at higher levels given strength in health insurance margins due to the relative lack of medical procedures in 2020 during the pandemic, but this older data fell out starting with the October report.

Implications for the macro outlook

Overall, we believe October’s softer-than-expected CPI reading strengthened the case that inflation will indeed moderate in 2023 after a period of elevated inflation due to material pandemic-related supply constraints coupled with large fiscal transfers. Nevertheless, we still believe inflation is likely to be generally stickier, and to hang above the Fed’s target even when it does moderate. Furthermore, in the near term we wouldn’t be surprised to see some temporary re-acceleration as hurricane-related replacement demand temporarily lifts prices in some goods categories. Also of note, while we expect reported health insurance prices will continue to drop, because this data is not included in the PCE (U.S. Personal Consumption Expenditures and the Fed’s preferred inflation measure), the “wedge” between the two inflation measures is likely to narrow over time.

Finally, we believe the implications of the October CPI report were not universally positive for the economic outlook. Indeed, a surprisingly weak inflation reading likely reflects softer consumer spending, and increased margin pressures for the corporate sector. Retail margins overall have held up surprisingly well in recent quarters; however, we expect falling real consumption will tend to moderate retailers’ ability to maintain those margins. We will monitor retail sales data and major banks’ credit card data as well, but in any event, October CPI suggests there are downside risks in the outlook for consumer spending.

Please visit our Inflation and Interest Rates page for further insights on these key themes for investors.

Tiffany Wilding is an economist and regular contributor to the PIMCO Blog.

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Tiffany Wilding

North American Economist

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