CPI Report Shows Inflation Falls Below 5% But How Will The Fed React?

The U.S. Federal Reserve will welcome inflation dropping below the symbolic 5% level for the first time in two years. But that may still be insufficient for the Fed leaders to cut rates as they look for inflation to return to their 2% goal. CPI inflation for the month of April rose 0.4% month-on-month and 4.9% year-on-year. Stripping out food and energy prices, the monthly increase was the same 0.4% and the annual increase was 5.5%.

Encouraging Signs

Shelter prices decelerated to a 0.4% month-on-month increase. Though shelter costs are still rising, that’s encouraging. It suggests home prices within the CPI index are trending down, after being a big driver of higher inflation over recent years.

In prior months shelter costs were rising at a 0.6% to 0.8% monthly rate. Home prices are starting to fall back from peak levels, is something industry indices have signaled since last summer, even if the early months of 2023 have seen a slight rebound.

However, the CPI uses a different calculation methodology that likely introduces a lag in its determination of home prices. If shelter costs continue to trend lower, then that will likely bring overall inflation down because shelter costs are a major component of the CPI.

The Fed’s Concerns

Yet, the Fed is likely to point out that inflation, though moving down from peak levels, remains well above its 2% goal. That’s why the Fed currently expects to hold rates at around current levels, or possibly even increase them further to make sure that inflation is firmly under control.

But even hawkish Fed decision-makers may be encouraged by aspects of May’s report. As high figures from 2022 continue to roll out of the 12-month inflation series over the coming months, it’s reasonable to expect the numbers to trend lower. That should ultimately create a setup for the Fed to feel comfortable cutting rates, though it has said that might not happen until 2024.

Other Factors

Energy costs, though on a declining annual trend, spiked in April primarily due to gasoline prices. For May, on current trends, energy prices could fall back but they did contribute to higher headline inflation for April.

Food prices, which had been running at high levels, were flat month-on-month for April. This paralleled March, giving a clear sign that the food inflation running at very high levels may now be over. Regarding vehicle prices, after trending down for months, used car costs spiked, but pricing for new ones fell in April.

What’s Next?

Nowcasts of May’s inflation currently project a 0.2% monthly rise in prices. Official May CPI figures will be released on June 13. Recent nowcasts, together with price hikes from 2022 falling out of the 12-month series, suggest that inflation may trend lower over the coming months — assuming no unexpected economic shocks.

The question is how Fed leaders choose to react to this. To this point they have been clear that inflation remains too high and more evidence of sustained decreases is needed. However, as inflation does move lower, the Fed may soften its approach over the coming months — perhaps not as fast as the market hopes.