U.S. headline inflation disappoints in May, uncertain if Fed will hike in December

The U.S. headline consumer price inflation fell on a sequential basis in May. The consumer price index dropped 0.1 percent month-on-month. The 2.7 percent fall in energy prices mainly drove the drop in consumer price index. This eased inflation on a year-on-year basis to 1.9 percent and thereby marks the first reading below 2 percent since November 2016.

Given that the energy prices were widely anticipated to fall, eyes were on core inflation, which rose a modest 0.1 percent in the recent string of weak readings. On a year-on-year basis, core inflation came in at 1.7 percent, which is the lowest reading in two years, noted TD Economics in a research report.

Core inflation stayed modes as several categories witnessed price declines. These included apparel, airline fares, medical care services and communication. Still, looking at wider core services, prices rose 0.2 percent in May, stronger than the earlier two months’ pace. The main shelter index that contributes one third to the main CPI basket was up 0.2 percent on a sequential basis. This rise was owing to 0.3 percent rise in rents and 0.2 percent rise in owner-occupied housing. On a year-on-year basis, shelter costs rose 3.3 percent and have been a key driver lifting services inflation in the last two years.

Meanwhile, another fall in core goods prices was more surprising. Core goods prices fell 0.3 percent. This marks the third consecutive decline and leaves prices 0.8 percent lower than one year ago. The U.S. dollar has usually softened in 2017; however, this is not yet showing up in higher prices at the consumer level, said TD Economics.

While May’s inflation report was unlikely to sway the U.S. Fed from its rate hike later today, the inflation report is expected to give the Fed pause as it considers rate hikes over the rest of the year. The fact that prices for core services have strengthened slightly gives some reassurance. Also, while core goods prices continue to be soft in May, price pressures are building at the import and producer level. It is likely just a matter of time before these are passed on to consumers, stated TD Economics.

Given the upstream price pressures, and an increasingly tight labor market, inflation pressures are expected to build through the rest of this year, added TD Economics. Especially for goods inflation, where the dampening impact of a solid U.S. dollar is increasingly in the rear view mirror. Still, the fact that these price pressures are proving slow to show up adds considerable risk to additional Fed hikes later this year, added TD Economics.

Labor markets in the U.S. continue to be solid, while communications from FOMC members have been clear that they continue to be focused on a tightening policy path. The Fed is believed to be committed to begin balance sheet runoff and is likely to announce on this at the meeting in September, noted Barclays in a research report. The subdued consumer price report for May lowers the conviction that the central bank would be able to hike rates for a third time in December, added Barclays.