Inflation runs out of puff

There are a number of reasons to expect US inflation to moderate in the second half despite May’s punchy headline number. This is important for investors because it would reduce the risk – at least the domestic risk – of another major step-up in US Treasury yields.

The first, and most obvious, reason for expecting inflation to moderate is that energy prices are unlikely to keep rising at their recent pace. Our US economics team expects the pop in energy prices to mean consumer prices will rise in the June quarter at an annualised rate of 5.75%. However, a moderate pullback in energy prices is then expected to cut headline inflation to below 1% annualised in the December quarter.

The second, and arguably more important point, is that slower growth should curb core inflation. Exhibit 1 shows GDP growth (extended using the latest forecasts by Richard Berner and David Greenlaw), along with the change in core CPI (that is, whether core inflation is rising or falling relative to 12 months earlier).

Even though growth seems set to rebound from the March quarter low, in four-quarter change terms we expect it to remain at below-trend levels in the second half of this year. Given the usual lags, the run of sub-trend growth should see core inflation moderate – as, indeed, Friday’s data suggests is occurring.

A third reason to expect inflation to moderate is the turn in the housing market. Housing is the largest single item in the CPI regimen. Shelter, a sub-component of housing, accounts for 33% of the CPI, and 42% of the core CPI.

Exhibit 2 shows there has been a significant divergence between shelter and the other components of core CPI. Yes, I know if I exclude everything that’s been going up, then it’s no surprise that inflation’s been going down – but I think it’s noteworthy that non-shelter core prices have been easing. (These prices account for 44% of the CPI.)

The important point going forward is that shelter costs seem set to ease, largely because of the apparent over-supply in the housing market. Exhibit 3 shows the “real” owner-occupied rent price (that is, whether it is rising or falling relative to other service prices) and the change in the rental vacancy rate. As should be expected, rental costs ease (with a lag) after a rise in vacancy rates.

A final reason to be moderately optimistic on the inflation outlook is that goods prices in the US continue to fall. They are not falling by much (Exhibit 4). But, considering the rise in raw material costs, the weakness in the US dollar, and the strength in global growth, I think it’s noteworthy that there have been no sustained price gains for (core) goods at the consumer level.

All this seems good news, particularly for bonds. But, remember one point: the bond market (like the Fed) is forward looking. That means it responds to leading indicators of inflation. As Exhibit 5 shows, bond yields have routinely moved in the opposite direction to inflation. It may be that what will matter more for bonds is not moderating inflation, but that US growth moderates in the second half from the expected strong June quarter out-turn.

Gerard Minack is an economist with Morgan Stanley.