US Weekly Economic Commentary: Immaculate disinflation?

The most significant economic news last week was the favorable Aug. 10 report on consumer prices for July. The headline CPI rose a modest 0.2% for the month, as did the core index. The 12-month change in the headline index ticked up from 3.0% to 3.2%, but the 12-month change in the core index continued edging down, from 4.8% to 4.7%. The 3-month annualized change in core prices dropped sharply from 4.1% to 3.1%.

From the details of this report (as well as the Aug. 11 report on producers' prices), we estimate a monthly increase of 0.18% in the core price index for personal consumption expenditures (PCE) in July, roughly half our earlier expectation of a 0.32% increase. All else equal, this encouraged us to lower our forecast of the annualized rate of core PCE inflation for the third quarter, from 3.3% to 2.7%.

That notable downward revision leaves a significant overprediction in our "Phillips Curve" model of inflation. A dilemma is how to interpret, and respond to, this error. The model views it as a temporary aberration reflecting, for example, the continued unwinding of pandemic-era idiosyncratic price pressures that arose from now improving supply chains.

In the model, such favorable "shocks" do not meaningfully alter the narrative that a rise in the unemployment is required to reduce inflation to 2%. However, a string of such misses would call into question our estimate of the relationship between labor market conditions and inflation, raising the possibility of an "immaculate disinflation" without a rise in unemployment.

It is too early to reach that conclusion. Some temporary factors currently suppressing inflation seem certain to wane or reverse. Crude oil prices have bottomed out so that energy costs — reflected not only in headline inflation (gasoline prices) but also in core inflation (for example, air fares) — likely will accelerate. Food prices may come under renewed upward pressure from the new interruption of agricultural commodities leaving Ukraine and the developing El Nino weather patten. Downward pressure on vehicle prices will ease once the industry rebuilds inventories to desired levels with the improved availability of microprocessors. Peculiarities of measurement are unsustainably driving down the CPI for health insurance.

Equally important are recent developments on the "real" side of the economy. On Aug. 7, we issued our updated US macro forecast showing an upward revision of real GDP growth for this year. Such firm growth allows little possibility of any easing in taut labor markets until next year. Indeed, we've lowered slightly our near-term forecast of unemployment, a revision that implies sustained pressure on wages and prices, particularly in the service sector.

The CPI report for July is consistent with our forecast that the Fed will skip a rate hike at the upcoming September meeting of the FOMC, and market participants now place almost 90% odds on the Fed standing pat then. We still expect the Fed to raise its policy rate to a peak range of 5.5% -5.75% in November, but an inflation report for August like July's could change our minds.

This week's economic releases:

• Retail and food services sales (Aug. 15): We estimate total retail and food services sales fell 0.1% in July, with sales outside of retail motor vehicle and parts dealers unchanged.
• New residential construction (Aug. 16): We estimate the annualized pace of housing starts rose in July to 1,443 thousand. This would leave them close to recent averages.
• Industrial production (Aug. 16): An increase in total industrial production (IP) in July would follow declines over the two prior months and be in line with flat trends over the last year or so.
• Leading economic index (Aug. 17): A decline in the Conference Board's Leading Economic Index (LEI) in July would continue a run of uninterrupted monthly declines that began in April 2022. There has never been a run of monthly declines of the LEI of this duration that was not associated with recession. Our forecast is for a period of below-trend growth and a rising unemployment rate, but not a recession.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.