On the Road To Disinflation

Eric Wallerstein & Ed Yardeni

This is an excerpt from Yardeni Research Morning Briefing, July 1, 2024.

For the past few years, financial markets have been keenly attentive to the core personal consumption expenditures deflator (PCED), the Fed’s preferred gauge of inflation. After climbing to a peak of 5.6% y/y in February 2022, the core PCED fell to 2.6% y/y in May, down from 2.8% in April. The headline PCED also came in at 2.6% y/y in May. On a m/m basis, the core PCED rose 0.08% and the headline index fell 0.08%. The softening in May gave markets a reprieve from higher prints in recent months—the core PCED is up 3.2% over the prior six months on an annualized basis (Fig. 1).

We expect the core PCED to reach 2.0% by year-end. Fed officials aren’t yet convinced, or perhaps they are just hesitant to claim victory too early. Many economists say the progress on inflation means that the Fed should cut interest rates to prevent economic harm (i.e., rising unemployment and a recession). We think the central bank should keep the fed funds rate (FFR) right where it is.

Before we make our case, let’s review the latest inflation and income data and extrapolate where they might be headed.

There are numerous glide paths that the PCED inflation rate could take during the final seven months of the year, and each incremental basis point of inflation can lead to a very different outcome. Fed officials updated their year-end forecasts at the June Federal Open Market Committee (FOMC) meeting, as shown in the quarterly Summary of Economic Projections (SEP). Their median forecast called for the core PCED to finish the year at 2.8% (up from their 2.6% March projection) (Fig. 2).

Fed Chair Jerome Powell remarked during the Q&A session of his June FOMC press conference that officials were mindful of base effects. Essentially, low monthly inflation prints during the second half of last year will slowly phase out of the y/y readings, meaning that the new monthly prints will have to be even lower to maintain the current pace of disinflation. In other words, the comps get tougher. Here are a few of the possible outcomes (Fig. 3):

(1) Mission accomplished. If the core PCED continues on its May monthly pace of 0.08% for the next seven months, the index would reach 2.0% y/y by year-end. For now, we’re in this relatively small camp.

(2) Close, but no cigar. Prints of 0.165% m/m (the monthly rate that equates to 2.0% annualized) would get the core PCED to 2.6% by December. That’s 0.2 percentage points below what the Fed’s SEP projects, a reading that officials expected would give them room to cut the FFR by 25bps before the end of this year. They might prefer two or three 25bps cuts if inflation is around 2.6% y/y by year-end.

(3) Take a hike. Seeing 0.2% m/m readings on the core PCED would take the index to 2.9% by year-end. We don’t expect this scenario, but a geopolitical event that causes an oil price shock or another global supply disruption that causes a rebound in durable goods prices are both legitimate risks. This outcome might lead financial markets to expect more interest-rate hikes.

(4) Shelter. Excluding rent prices, the core PCED is already at the Fed’s 2.0% target (Fig. 4). Housing inflation, down to 5.5% in the PCED, is falling slowly as lagging rents measured by the index catch up to market rents. Rent disinflation should continue (Fig. 5).

(5) Goods. The price of goods fell 0.1% y/y in May. Durable goods fell 3.2%, fueled by deflation across categories like autos and home furnishings (Fig. 6). Prices of some nondurables—like home supplies, magazines, newspapers, and stationery—also fell, but nondurable goods as a whole were up 1.6% y/y (Fig. 7). Much of the downward pressure on goods inflation can be attributed to lower import prices from China (-2.0% y/y in May), which continues to dump cheap goods. An escalating trade war and sweeping tariffs pose a threat to cheap Chinese exports.

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