The very good May inflation report was followed by an even better June inflation report, such that—if not for the unfortunate shift to a single rate cut in the June FOMC Summary of Economic Projections—a July cut might be a live possibility. As things stand, the market is now fully pricing a first cut in September and looking for nearly 2.5 cuts before year end. We had long favored June or July as the start of the cutting cycle, partly because beginning to ease right before the election is not ideal. However, if the choice is between September and November, the unemployment rate at 4.1% says “do not delay”.
The June inflation report was excellent…but do not expect a full repeat in coming months. Overall prices actually declined 0.1% m/m, lowering headline inflation from 3.3% to 3.0% y/y, the lowest in a year. Core prices (excluding food and energy) rose a soft 0.1%, lowering the core inflation rate by a tenth to 3.3%.
By far the most important piece of the report was the moderation in shelter inflation.
Rent of shelter costs increased by only 0.2% m/m—the least since August 2021—as rent of primary residence and owners’ equivalent rent rose 0.3% m/m, and lodging away from home declined 2.0% m/m (the most since October). This may not be repeated so we are reluctant to pencil in equally good reading on overall shelter for the next few months, but we believe that the downshift in primary residence rent and owner’s equivalent rent has staying power. Even lodging away from home could remain under pressure both from a pullback in travel-related spending by more cost conscious consumers, and some possible immigration-related relief. The latter is extraordinarily hard to quantify, but we remain open to the possibility. The snail-pace improvement in shelter inflation has been frustrating to witness given the more benign market-based readings of rent inflation, but at least the progress continues. We look for shelter inflation to slow about one percentage point through year end, from June’s 5.2% y/y to 4.3% y/y by December. We see potential for even better outcomes, but prefer to remain cautious.
Inflation was heavily flattered in June by lower energy prices, which slid 2.0% m/m on a 3.8% m/m plunge in gasoline prices. This will not be the case again in July. Food prices increased 0.2%, driven primarily by the “food away from home” category. Broad service categories were very well behaved, likely overstating the sustainable run rate for these categories (Figure 2). Medical services, recreation, education and communication, all posted modest gains or even outright declines. We look for a sequential acceleration near-term, but the fact that we have two months now that “broke” the steady prior uptrend is important. As for motor vehicle insurance—a key driver of higher services inflation lately—prices rose m/m following May’s unusual decline, but did so at a much slower pace than through much of the past year. Some relief may be in the pipeline in this segment as premiums catch up with previous increases in underlying replacement costs.
Even as inflation is coming down, the Michigan consumer sentiment index has failed to meaningfully rally, suggesting a broader sort of malaise taking hold. In the preliminary reading for July, the headline unexpectedly dropped 2.2 points to an eight-month low of 66. Consensus expectations had been for an incremental improvement. Notably, the current situation metric declined to its lowest level since December 2022; expectations declined to a seven-month low. The good news is that Inflation expectations eased in what is primarily a delayed reaction to lower gasoline prices in May and June. Short-term (1 year) inflation expectations eased a tenth to 2.9%, which marks the lowest level since 2020 and a level that had since been reported previously just in January and March this year. Long-term (5-10 year) inflation expectations eased a tenth to 2.9%.
This dynamic is to some degree reflected in the NFIB (National Federation of Independent Business) index, which measures sentiment among smaller firms. Thyis metric has languished throughout the Covid recovery even as other macro indicators surged. The two main reasons were the intense competition for labor and the surge in inflation, which smaller businesses are generally not as well equipped to handle than their larger counterparts. Both of those concerns have faded notably, however, yet small business sentiment is still quite subdued. Why? Part of the story is that those earlier concerns about inflation and difficulty finding workers are gradually being replaced by another, perhaps even more ominous: lower sales. The deterioration in the sales outlook is in a fairly incipient stage, but bears close watching because in prior cycles it has prefaced a recession. Small businesses have a higher exposure to the average consumer and so the demand outlook may be dimming a little faster now that lower-income consumers are tightening their belts.
Admittedly, the headline NFIB index rose 1.0 point to a six-month high of 91.5, and the outlook for general business conditions improved to the highest since early 2022. We take this to reflect lower inflation and more ease in finding workers. Indeed, the share of respondents saying they have job openings that are hard to fill declined to match the lowest level since January 2021. Similarly, the share of respondents saying inflation is their biggest problem declined sharply. Meanwhile, profits were little changed while hiring and capex plans were steady.
It is in this context that unemployment claims are becoming a more relevant indicator than they have been for a while. Initial claims retreated 17k to 222k in the week ended July 5, but continuing claims were little changed and the four-week moving average of continuing claims rose to the highest level since December 2021.
Consumers have been more frugal lately, especially with their use of credit. Total consumer credit rose by 11.4 billion in May, with about two thirds of that accounted for by revolving credit (mostly credit cards) and the rest non-revolving credit (student and auto loans). High interest rates are discouraging consumers from using revolving credit: the three-month annual growth rate of revolving credit slowed to 4.2% y/y in May, the slowest increase since May 2021.