The latest CPI report essentially eliminates the chance that the Fed will cut interest rates in May, but they’re still likely to cut in June.
Core inflation came in slightly higher than expected in February. There are reasons to be worried about inflation getting stuck, but it’s not time to panic. Rates will end the day slightly higher today, and any hope for a May rate cut is probably gone now. But the Fed is still likely headed for a June rate cut.
The details. Headline inflation came in at 0.4% MoM as expected and 3.2% YoY, just above 3.1% expected. Core inflation (the key gauge of underlying inflation, excludes volatile food and energy prices) came in at 0.4% MoM vs. 0.3% expected, and 3.8% YoY vs. 3.7% expected. However, it’s not as bad as it looks because much of it was unlucky rounding. Expectations were for 0.32% MoM and it came in at 0.36% MoM, rounding to 0.4%.
Shelter inflation, which makes up almost half of core CPI, retreated from a suspicious January surge, but it’s still higher than expected. After surging in January to 0.6% MoM, rent came back to 0.4% MoM in February. Notably, owners’ equivalent rent (an estimate of how much rent homeowners would pay for their house) was oddly high compared to rent of primary residence in January, which appeared to be a statistical fluke because the two measures are based on the same underlying data, just weighted differently. This month, owners’ equivalent rent fell back in line with rent of primary residence, confirming that January was an oddity rather than a trend. This was especially important for shelter because it is such a large part of household expenditures and, therefore, inflation.
Importantly, shelter inflation in the CPI still has yet to catch up with real time rent data, which has been flat for a while. This implies that shelter inflation still has room to come down. However, the increasingly long lag makes us worried that there are enough compositional differences between real time rent data and CPI shelter that this component won’t fall as much as forecasters have been expecting.
Some of the statistical noise from January dissipated–but not all. As described above, shelter inflation normalized in February after an odd January report. However, some of the statistical noise in January mechanically continues into February because many of the CPI surveys are done on a bimonthly basis, so we should expect any remaining effects to dissipate next month.
The Fed is focused on PCE (an alternative measure of inflation) which will likely come in lower. The Fed adjusts monetary policy based on the PCE, an alternative measure of inflation, which is released toward the end of the month. While it is similar to CPI, it measures a wider range of goods and services, including, notably, services that are paid on your behalf, such as medical benefits. PCE also has a much lower weight on shelter inflation, which has been the main driving force behind high CPI reading. Therefore, the gap between CPI and PCE has widened in recent months. Some of the components pushing up this core CPI reading won’t be as important in core PCE, such as shelter and airline fares. Also, food away from home is not in core CPI, but it is in core PCE, and it came in very low, at 0.1% MoM. That means the Fed’s view of inflation using core PCE is likely to look rosier than the picture we got today.
The possibility of a May rate cut is almost certainly gone, but a June rate cut is still likely. Prior to today’s news, the base case was the Fed making its first of three cuts this year in June. There was also some hope for a cut to come a little earlier, in May, if we got good data. With only one more inflation reading before the May meeting, a cut in May seems highly unlikely. They are still likely to cut rates in June if the next two months of data are decent. Fed Chairman Jerome Powell previously said the inflation data doesn’t need to get better for them to start cutting, it just has to stay good. Furthermore, they are likely to be reluctant to start cutting too late in the year as it gets closer to the election.
Aside from when they start cutting, there is also the question of how many cuts. With this data, there is now some possibility they will trim their previous forecast of three cuts this year back to two. The Fed is set to release an updated forecast next Wednesday after their meeting.
Mortgage rates will drift up a little higher today, reversing some of the drop last week. Markets reacted with rates slowly drifting upwards today. We should expect mortgage rates to end the day slightly higher than yesterday. But mortgage rates fell 27 basis points last week, so they will still be lower than recent weeks.
For homebuyers and sellers, this news brings on some nerves. But we still expect mortgage rates to fall gradually this year as the Fed cements its outlook for three rate cuts starting in June.
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