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Drop in Inflation Trumps The Strong Jobs Report

Scott Anderson
Chief Economist
Bank of the West

The stronger than expected July jobs report put the market on alert that the Fed might need to do another 75 basis point hike in September, but this week brought some welcome relief on the inflation front that gives the FOMC a bit of room to scale-back the pace of recent rate hikes to a still outsized 50 basis point hike at the September meeting. If realized, this would be in-line with our current forecasts, bringing the Fed funds target rate up to a range of 2.75 to 3.0% by this Fall. In our view, while we still have another employment report and inflation report to digest before the Fed's next meeting, the sharper than expected drop in inflation in July trumps the stronger than expected jobs report. In this Outlook Report we delve deeper into the July CPI inflation numbers and discuss the implications for the inflation outlook.

It has taken us all year, but we finally received some welcome relief on inflation in July. The headline CPI index was unchanged from June and on an annualized basis actually declined a bit down 0.2%. This was a sharper than expected deceleration from the 1.3% increase we saw in June. Prior to the release of the report, we were forecasting a deceleration in inflation, but a still positive 0.3% increase in overall consumer prices on the month.

Headline Inflation Goes Into Hibernation in July

This is the first monthly drop in consumer prices since the 9.2% annualized drop seen in April 2020 when COVID shut down much of the U.S. economy. You would be forgiven at this point if you find yourself confused. Isn't inflation out of control you ask? We were coming off the month of June when it seemed everyone and their brother raised prices on consumers with annualized inflation that month reaching a new pandemic high of 17.1%. So what happened between June and July you ask? Looking into the details of the report we see strong evidence of measurable declines in consumer demand and a further easing of supply shortages and port backlogs. However, the biggest driver of the decline in inflation pressures last month was the 4.6% monthly drop in overall energy prices and the 7.7% decline in gasoline prices. In fact, if energy prices had just remained unchanged in July, headline CPI inflation would have been 0.4 percentage points higher last month. The drop in energy prices also helped cut housing inflation in half last month down to a more manageable 0.4% from a 0.8% increase in June. That's because home utility and fuel prices declined 0.3% in July after jumping a whopping 2.5% in June and 2.9% in May.

Beyond energy though, there were encouraging signs that the moderation in consumer demand was already cooling inflation in a number of sectors that have seen outsized price increases in recent quarters. Airfares declined 7.8%, goods prices dropped 0.5%, used car prices slumped 0.4%, and apparel prices fell 0.1%. The combination of a strong U.S. dollar, which helps moderate the import price inflation of goods, and rapidly rising retail inventories are helping to push retail apparel and goods prices lower. Even inflation of services moderated to 0.3% last month from 0.9% in June. The lone disappointment was the lack of progress on the food inflation front. Food and beverage inflation accelerated to 1.1% in July from an already elevated 1.0% increase in June and 1.1% gain in May.

Other reports hint at further improvement on the supply-side of the economy as well. The New York Fed's Global Supply Chain Pressure Index improved for the third month in a row to 1.84. This is the best reading on this measure of global supply chain pressures since January 2021.

Container rates from China to the West Coast of the United States fell back to early 2021 levels in the first week of August to just $6,593 from a $20,586 peak in September 2021 - a 68% drop. Finally, the large drop in raw commodity prices and reduced shipping costs led to a steep drop in the Prices Paid component of the ISM Manufacturing Index for July to 60.0 – its historical average since 2000. These are all encouraging developments that should help keep consumer inflation on the moderating trend it started last month.

So where do we go from here? For the first time this year, the better than expected inflation numbers for July prompted us to lower our forecast for CPI inflation over the next six quarters.

Inflation Forecast Cut For The First Time This Year

The inflation outlook is still not great when you look at the year-on-year trends, but by the fourth quarter of 2022 we think CPI inflation year-on-year will be closer to 7.3% instead of the 9.1% level it hit in June. By the second half of 2023, the U.S. economy has a good shot at CPI inflation averaging between 3.5 and 3.2%.

To learn more, check out this week's U.S. Outlook Report.

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