Inflation Break?

July brought a measure of relief on the inflation front. Because of a 4.6% drop in energy prices, the overall consumer price index (CPI) for the month showed no inflation. The stock market took the news to heart, so much so that the benchmark S&P 500 Index rose 1.7% on the opening bell. Investors seem to think that the good news will convince the Federal Reserve (Fed) to abandon its anti-inflationary efforts, stop raising interest rates and provide liquidity more liberally to financial markets. Should the Fed respond this way, it would make a big mistake. One month does not reverse any trend, especially one that has gained considerable momentum for over a year. Details from this latest CPI report make this fact clear.

Food is the first consideration. It is the largest single part of America’s household budget, and it rose 1.1% in July alone, an annual inflation rate of 14% and a distinct acceleration from the 10.9% averaged during the last 12 months. This picture alone, regardless of any other consideration, pressures households and the Fed, and also has political ramifications.

Nor is it likely that energy prices will in coming months continue to provide the relief they did in July. For some time now a shortage of refining capacity has pushed up gasoline and fuel oil prices faster than those on crude oil. The July drop in retail energy prices seems to signal that the production of refined products has at last caught up with demand. With this adjustment now more or less complete, gasoline and heating oil prices should return to tracking those of crude oil. And those prices have picked up again. The price of a barrel of benchmark West Texas Intermediate grade hit a low of $88.54 at the beginning of August. Since, it has risen to $91.41 a barrel. Even if it goes no farther, the hike already in place points to a 3.2% rise in retail energy prices in August and a reversal of a big part of the July drop.

For the rest of the inflation index — the so-called “core” measure, which excludes food and energy — July brought only modest relief. This measure between April and June rose between 0.6% and 0.7% a month or at a 7.8% average annual rate. July showed a monthly gain of 0.3% or a 3.7% annual rate. If this were to hold, it would still exceed the Fed’s preferred inflation of 2.0%. But it is not apparent that the economy will realize even this relative moderation in inflation.

Part of July’s break in “core” inflation reflected a 0.5% drop in the prices of transportation services, a direct result of the drop in energy prices that, as already indicated, will not likely persist. A 0.4% decline in used car prices also helped hold back the pace of core inflation in July, but this is a notoriously volatile component of the CPI and is as likely to surge in August as repeat its decline. Against these unreliable sources of relief, the prices of rent and housing continued in July to show the 8% annual rate of advance they have averaged all year, while ominously, the price of medical services accelerated from the 4% annual rate of increase it had averaged so far this year to a 5% annual rate in July.

Of course, anything is possible, but the likelihoods suggest three things: Matters are not nearly as good as the headline number suggests. If there is any relief in the outlook, inflation will continue at an unacceptable and burdensome pace. The Fed would make a mistake if it reversed its stated determination to keep up its counter-inflationary policies.