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The FOMC did the minimum expected of it yesterday, raising rates by 25bp--with a 20bp increase in IOER--and dropping one of its dots for 2019.
The plunge in gas prices since their peak last summer likely will exert modest downward pressure on core inflation by the end of this year, via reduced costs of production and distribution, but it probably is too soon to start looking for these effects now.
The failure of the core CPI to mean-revert in April, after the unexpected March drop, does not mean that the Fed can relax.
After four straight sub-consensus core CPI readings, we think the odds now favor reversion to the prior trend, 0.2%, over the next few months.
Housing rents account for some 41% of the core CPI and 18% of the core PCE, making them hugely important determinants of the core inflation rate.
When FOMC members sit down to begin their two-day meeting on September 16, the August CPI numbers will have just been released. We expect the data will show core inflation at 2.0% or a bit higher, up from a low this year of just 1.6%. Shorter-term measures of inflation will, we think, be 2¼-to-½%. These numbers are not outlandish; they just require the monthly gains in the core CPI to match June's pace, which was in line with the average for the previous six months.
The Fed headlines yesterday carried no real surprises; rates were cut by 25bp, with a promise to take further action if "appropriate to sustain the expansion".
Today brings a huge wave of data, but most market attention will be on the June CPI, following the run of unexpectedly soft core readings over the past three months.
July's fifth straight undershoot to consensus in the core CPI was very different the previous four. Only one component--lodging away from home--prevented the first 0.2% month-to-month print since February.
Our base case forecast for today's July core CPI is that the remarkable and unexpected run of weak numbers, shown in our first chart, is set to come to an end, with a reversion to the prior 0.2% trend.
On the face of it, our forecast of higher core inflation by the end of this year is seriously challenged by the recent data.
For the past six years, the PCE measure of core inflation has undershot the CPI version. The average spread between the two year-over-year rates since January 2011 has been 0.3 percentage points, and as far as we can tell most observers expect it to be little changed for the foreseeable future.
The downside surprise in the November core CPI, which rose by 0.1%, a tenth less than expected, was due entirely to an unexpected 1.3% drop in apparel prices. This alone subtracted 0.05% from the core, but we think the chance of a reversal in December is quite high.
The Fed will do nothing to the funds rate or its balance sheet expansion program today.
No surprises in the statement; the IOER cut is technical, not a policy change.
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