ING | Easing US Price Pressure Dampen Imminent Fed Hike Talk

US June consumer price inflation data undershot expectations with the breadth of the softening the particularly encouraging aspect. Fed rate hike pricing has receded, but we still think it is too high. We forecast a prolonged pause from the Federal Reserve

US inflation lower than anyone expected

Today’s consumer price inflation report for June was considerably softer than expected. US headline prices fell -0.4% month-on-month versus consensus expectations of a -0.1% outcome, while core inflation (ex-food and energy) was flat on the month versus expectations of a 0.2% increase. To three decimal places, it was a negative print of -0.017% MoM. As a result, the annual headline inflation rate slows to 3.5% year-on-year from 4.2% while core inflation slows to 2.6% from 2.9%.

The details show gasoline prices fell 9.7% MoM, but there were also falls in education & communication of -0.8% MoM, used cars (-0.2%), apparel (-0.6%), medical care fell 0.1% while shelter, the largest component within CPI, rose just 0.1%. New vehicle prices were flat on the month while other goods and services rose just 0.1%. The only real source of strength was recreation (+0.5%), which may reflect the World Cup to a certain extent. The encouraging aspect of this report is the breadth of the softness – it wasn’t steep falls in one or two components that offset robust price increases elsewhere. The chart below shows core inflation metrics with the black line representing 0.17% MoM, which is the run rate required to bring core inflation down to 2% YoY.

US core inflation metrics (MoM%, 3M annualised and YoY%)

Source: Macrobond, ING

Kevin Warsh testimony says all the right things

Federal Reserve interest rate hike expectations had been building in recent days, reflecting the re-escalation of the Middle East conflict, the stalling of shipping through the Strait of Hormuz and the move higher in oil and natural gas prices. However, today’s relatively benign inflation outcome, showing broad-based softening in price pressures, is resulting in a steep reversal with the 10Y yield down 6bp and 2Y treasury yield down 10bp on the back of the headlines. Yesterday, a July rate hike was seen as a coin toss, but right now less than 4bp of a potential 25bp hike is priced. 50bp of hikes had been expected by March next year as of today’s open, but that has since dropped back to 44bp by April.

At the same time, we have had the release of the text to Fed Chair Kevin Warsh’s semi-annual monetary policy testimony to Congress, set for 10:00am. It largely echoes his June FOMC press conference. The headlines say all the right things about being vigilant and being prepared to take action to ensure inflation returns to target – making sure “the inflation surge of the last five years will be a thing of the past”. The headline news outlets are focusing on is that he and the FOMC have “no tolerance” for persistently high inflation, which really shouldn’t be any new ‘news’ seeing as the primary role for the Fed is maintaining price stability. As we expected, there is very little there that can be described as ‘forward guidance’ given his disdain for it. Comments in the Q&A about today’s CPI print will be the focus – he will surely welcome it, but will likely insist that a series of cool prints will be required.

Four reasons for inflation to slow into 2027

The deterioration in the Middle East situation has led shipping transits through the Strait of Hormuz to collapse after their recent revival and this is putting upward pressure on oil and natural gas prices. Nonetheless, WTI oil at $80/bbl remains historically consistent with retail gasoline prices of around $3.75/gallon, below the current level of $3.85. Should talks resume, and a deal is done, we should see oil and gasoline prices head lower once more.

A second reason, and more important reason, for us to expect inflation to continue slowing is housing. As Fed Chair Kevin Warsh said at the June FOMC press conference, monetary policy doesn’t appear restrictive when considering the robustness of financial markets, but it does in light of the housing market. That is hugely important, given that the component with the heaviest weighting in the CPI is shelter, at 35%. Shelter inflation is currently running at 3.3% year-on-year. With home prices barely rising 1% and rents now falling outright in a growing number of states, according to data from Zillow and Realtor.com, we expect this dominant housing component to exert steady downward pressure on overall inflation over the next 12 months.

Thirdly, there are undoubtedly issues around semiconductor prices, but the biggest cost input for US corporates is not tech, tariffs or energy. It’s the cost of workers. We’ve gone from a situation where, in 2022, there were two job vacancies for every unemployed American to being in balance today. This has taken a huge amount of froth out of wages. Moreover, the plunge in the quits rate – a measure of labour market churn – means companies are no longer having to pay up to retain staff. Wage inflation of 3% is fully consistent with 2% consumer price inflation.

Then, rounding out the story, we have tariffs. They represent a one-off step change in prices. Now that we’ve arguably entered a less onerous tariff regime that includes lots of exemptions, we’re increasingly confident that their upward influence on inflation will rapidly fade. The Dallas Fed believes tariffs are contributing around 0.9pp to the annual rate of core PCE deflator. As this drops to zero, core inflation should quickly descend. Moreover, Federal budget balance data showed the IEEPA ‘Liberation Day’ tariffs, that were struck down by the Supreme Court, are now being repaid to corporate America. In May the section 301 tariffs (the new regime) were fully offset by the initial repayments of the IEEPA tariffs. In yesterday’s June data, the Treasury actually paid out $25.5bn more in IEEPA refunds than it received under all other tariffs. With perhaps another $80bn of refunds still to be made, this boost to corporate cash flow should also be helpful in limiting consumer price increases.

A prolonged pause to next summer is our call

We recognise that the Fed has missed its inflation target for the past five years, and Kevin Warsh wants to put an end to this trend. Nonetheless, consumer inflation expectations are within tolerable ranges, suggesting little risk of second-round price effects from the energy spike. Meanwhile, market inflation expectations have plunged, with 10Y break-even inflation rates in line with their 25-year average, while those for 2Y inflation have dropped below 2%. To us, the more likely course of action is for the Fed to hold rates steady for a prolonged period, perhaps until the summer of next year.

Compliments of ING – Member of the EACCNY