May CPI report: Inflation deceleration paves the way for a policy pause in June

The Consumer Price Index (CPI) for May showed that headline inflation continues to decelerate, dropping sharply from 4.9% last month to 4.0%, the lowest level since April 2021. However, core inflation is proving significantly stickier and remains above 5%.

Commentary from Federal Reserve (Fed) speakers had suggested that it would take a meaningful upside inflation surprise to convince them to hike at their June FOMC meeting, tomorrow. With headline inflation coming broadly in line with expectations, tomorrow’s meeting will likely be the first since March 2022 without a policy rate hike. Yet, with core inflation remaining stubbornly elevated and still a cause for concern, prospects for an additional hike at the July FOMC meeting are very much alive.

Consumer Price Index
Year-over-year % change, 2010–present

Report details

• Headline CPI rose 0.1% month-on-month in May. This was broadly in line with expectations and represents a meaningful slowdown from the 0.4% increase last month, primarily driven by a drop in energy prices. Annual headline CPI is now less than half its June 2022 peak of 9.1%, and continues to head in the right direction.
• Annual core CPI (which excludes food and energy prices) eased from 5.5% to 5.3%, slightly higher than expected. Monthly core inflation was in line with expectations, but at 0.4%, it has been essentially unchanged since December last year. This sideways move should concern the Fed. Indeed, if monthly core inflation remains at 0.4% for the remainder of the year, annual core inflation will finish 2023 close to 4.5%.
• Within core CPI, core goods inflation was again strong, rising to 0.6% month-on-month in May as used car prices registered another sharp increase. Low inventory levels and strong demand suggest that used car prices will continue to see upward pressure over the coming months.
• Core services inflation remained unchanged at 0.4% in March. Housing inflation decelerated only marginally, with owners’ equivalent rents and shelter inflation both rising 0.5% on the month. While the Fed shares the widely held expectation that rent inflation will slowly abate as new leases are signed at more favorable prices, the deceleration is certainly taking longer to materialize than expected.
• Core services ex-housing inflation, the main focus of Fed Chair Jerome Powell due to its link to the labor market, rose slightly from 0.11% in April to 0.24% in May. While this is a slight acceleration, it is still lower than the 1Q average, suggesting that Fed policy is taking effect on the important segments of core inflation—albeit slowly.

Today’s inflation report is unlikely to trigger an eleventh consecutive policy rate hike tomorrow. Fed policymakers had previously voiced their preference to pause their hiking cycle in June, permitting them to evaluate the incoming economic data, and the June CPI report is simply not hot enough to change that perspective.

However, the ongoing strength of the labor market, coupled with the stickiness of core inflation, means that tomorrow’s FOMC meeting will likely represent a “skip” rather than a “pause.” Without a meaningful downside surprise in both jobs and inflation, a final interest rate hike remains in the cards for July.