With markets understandably captivated by the upcoming SpaceX IPO – one of the most anticipated listings in recent years – we decided to turn our attention elsewhere this week and refocus on a different market driver US inflation.
US inflation for May came in at 4.2% year-on-year – in line with expectations but well ahead of the Central Bank’s 2% target and a sharp increase from April’s figure (see chart below). As you might have expected, higher oil prices drove the increase, with the energy component of the Consumer Price Index (CPI) basket rising around 23% year-on-year.
The good news from the release is that core inflation (excluding food and energy) was fairly well-behaved – rising year on year, as the chart shows, but overall quite well-behaved given a fairly robust labour market. We think that partly explains why market expectations for inflation a year from now have actually fallen over the past few months (see chart of US inflation swaps below). We should remember that central bankers and investors might focus on core inflation, but households pay for everything (food and petrol included). Headline inflation matters more for the consumer!
It’s a reminder that so far at least the closure of the Strait of Hormuz has had much less of an impact on energy prices than we might have feared prior to March. We’d also infer that investors continue to expect a resolution to the conflict in the Middle East that will increase the flow of energy through the Straits.
For now, we think this means US central bankers won’t raise interest rates at their meeting next week, which is a widely held view. It will also be interesting to see what impact the new Fed Chair, Kevin Warsh, might have. President Donald Trump is clearly hoping for lower policy rates in the future, but with inflation so far above target, it’s tough to see the path to lower rates in the short-term.
Currently, investors expect to see one 25 basis point rate hike in the US this year – a significant shift from the expectations of rate cuts earlier in the year. Given the relative resilience of the US labour market, we think this seems like a reasonable range (not very different from keeping rates flat for the rest of the year, we’d argue). We think the Central Bank will tolerate inflation above target, given that it has come from a supply shock. The key assumption here is that for now we don’t see core inflation accelerating in the way that headline inflation has done. If prices excluding food and energy accelerate, we think the Central Bank could hike rates more aggressively.
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