Core Inflation Data Could Prompt Dramatic Action at the Fed

by Tiffany Wilding, Allison Boxer of PIMCO, 7/15/22

June’s U.S. CPI (Consumer Price Index) inflation data likely set alarms blaring in the minds of Federal Reserve officials. Core inflation now appears broadly entrenched across goods and services, which should solidify Fed officials’ confidence that restrictive policy is appropriate. We now expect the Fed to announce, at minimum, another 75-basis-point (bp) hike in the policy rate at both the July and September meetings, with growing risks of a 100-bp hike.

At the same time, we believe June’s inflation reading raises the odds of recession, which we now estimate is more likely than not in the next 12 months. Indeed, it is increasingly likely that the Fed will need to engineer an outright contraction in real activity to moderate inflation back to target over the next few years. If inflation turns out to be more persistent in the face of slower activity, a more severe contraction may be needed.

A closer look at the inflation data: rents and core goods

June headline CPI increased 1.3% month-over-month (m/m), firmer than consensus expectations. Especially concerning is that while food and energy prices may have peaked in June, underlying core inflationary pressures appeared to accelerate. The monthly price increase in rents and owners’ equivalent rents (OER) accelerated further and appear poised to remain at elevated inflation levels at least through year-end. Counterintuitively, Fed policy rate hikes actually tend to boost rental inflation at first, because they usually make owning a home less affordable, pushing more people into rental markets. Typically it’s not until housing price inflation starts to moderate that rental inflation also starts to fall. Reported CPI inflation tends to lag broader housing market trends.

Meanwhile, there was very little evidence of price discounting across core goods categories, despite reports of higher inventory levels and slower real goods consumption. Our aggregate measure of retail goods inflation reaccelerated in June, while auto inflation also remained firm. That retail inflation is continuing to accelerate despite a slower recent pace of spending suggests that inflation may be more entrenched than previously thought.

Despite June’s data, we still think inflationary trends in U.S. core goods markets are likely to moderate. Wholesale used vehicle prices resumed their fall in late June, inventory-to-sales ratios have surged across several retail categories, and the U.S. appears to be close to freight recession (i.e., a multi-quarter decline in freight volumes). Nevertheless, inflation’s broad-based reacceleration over the past few months suggests it is less responsive to moderating real demand.

Broader implications: Fed policy, recession risk

For the Fed, the relevant monetary policy discussion has likely shifted from “Is restrictive monetary policy appropriate?” to “How restrictive?” At a minimum, the current level of the fed funds rate – which is still accommodative – appears out of sync with the economic situation and U.S. domestic inflationary pressures.

A faster pace of monetary tightening also means a U.S. recession is more likely than not over the next 12 months, in our view. We’ve already witnessed a rapid deceleration in economic momentum and this loss of momentum has occurred before the Fed’s actions to slow the economy have been fully felt, suggesting that the depth and breadth of an economic contraction could be more pronounced across sectors than previously thought.

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

Tiffany Wilding and Allison Boxer are economists and regular contributors to the PIMCO Blog.

Core Inflation Data Could Prompt Dramatic Action at the Fed

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