Inflation hits 3%. The easy part is over

Headline US consumer price inflation fell to 3.0 per cent in June, and plenty of commentators declared the war won. The drop from nine per cent was fast. Much of it was arithmetic. The spike in energy and food prices in mid-2022 has rolled out of the twelve-month comparison, which flatters the annual figure.

How the arithmetic works

An annual inflation rate is simply the sum of the past twelve monthly price changes, compounded. When a very large monthly rise drops out of the window and is replaced by a small one, the annual figure falls even if nothing about the underlying pace of price growth has changed. June 2022 was the peak, when the annual rate reached 9.1 per cent, and the months around it carried big jumps in petrol prices after Russia's invasion of Ukraine. Replacing those with this year's modest readings did most of the work in bringing the headline down to 3.0 per cent.

The same arithmetic is about to turn. After last June, petrol prices fell sharply, and headline consumer prices were flat in July 2022 and barely rose in the months that followed. Those small numbers are what this year's monthly readings will now be compared against. For the headline rate to keep falling, prices will have to rise even more slowly than they did in the second half of last year, which is a much taller order.

Energy could make the order taller still. Saudi Arabia began a voluntary cut of a million barrels a day in its oil output this month, on top of earlier reductions agreed by the wider OPEC+ group, and has already extended it into August. If crude prices firm as a result, petrol will add to monthly inflation just as the flattering comparisons disappear. In that case the headline rate could rise in the autumn even while the core drifts lower, a combination that would make the Fed's communication harder and markets' hopes of early cuts look premature.

Base effects run out

Core inflation is still 4.8 per cent, and the easy part is finished. Base effects turn neutral in the second half of the year and then start working against the Fed. Getting core inflation from five per cent to two per cent means slowing rents and wage-heavy services such as medical care and recreation, prices that rarely come down quickly.

Some of those prices are finally moving. Core prices rose only 0.2 per cent in June from May, the smallest monthly gain in almost two years, helped by falling used-car and airline prices. A monthly pace of 0.2 per cent, sustained for a year, would be consistent with an annual rate of about 2.4 per cent. One month does not make a trend, however, and the core measure has produced false dawns before. It would take several more months of readings like June's before the Fed could treat it as a new pace.

Where the stickiness sits

Shelter remains the largest single contributor to core inflation. The official measure tracks rents paid by all tenants, most of whom are on leases that reset only once a year, so it lags behind market rents by many months. Private indices of new leases have cooled markedly, which means the official shelter figures should slow over the coming year. That is genuine relief on the way, but it arrives on a schedule set by lease renewals rather than by the Fed.

The harder part is the rest of services. Car insurance, repairs, medical care, recreation and personal services all depend heavily on labour costs, and wage growth, though slowing, is still running well above the pace consistent with 2 per cent inflation. With unemployment near its lowest level in decades, those prices have little reason to slow sharply until hiring does.

A precedent from the 1970s

The danger of mistaking a falling headline for victory has history behind it. In the mid-1970s American consumer price inflation more than halved from its 1974 peak within two years, as the first oil shock faded. The Fed eased, the economy recovered, and inflation climbed back to double digits by the end of the decade, requiring the far more painful tightening of the Volcker era. Today's Fed is well aware of that episode, and its officials cite it often.

The parallel is imperfect. Inflation expectations are far better anchored now, and the Fed has moved faster than it did then. But the structure is similar: a supply-driven spike fades from the numbers, leaving a stubborn core that depends on wages and domestic demand.

Who is betting on what

Markets cheered the June figures. Bond yields fell and equities rallied on the view that the Fed's next rate rise, widely expected at its meeting later this month, might be its last. Investors who have bought longer-dated Treasuries in anticipation of cuts early next year are the most exposed if core inflation stalls. Borrowers hoping for relief on credit cards, car loans and floating-rate business debt have the same problem.

Savers and holders of short-term bills are the natural winners from stickiness, since a Fed that cannot cut keeps short-term yields high. So are workers whose pay is finally rising faster than prices, at least until the labour market weakens.

The optimists' best argument

The strongest case against this column is that the June core number is not a fluke. Goods prices are falling, shelter inflation has a predictable downward path, and the labour market is cooling at the margin. If those forces combine, core inflation could fall faster in the second half than base effects alone would suggest.

That may prove right, but it rests on everything going well at once. The column's point is narrower: the headline has had its easiest months, and from here it will be measured against a much lower base. The figures to watch are monthly core readings, the shelter index and wage growth. The three per cent headline owes a great deal to base effects that are about to expire. By the autumn the Federal Reserve will be left fighting a core rate that is proving very hard to shift, and the headline itself may edge up again before the year is out.