The May CPI Report Is An Outlier – And The Fed Seems To Agree (SP500)

The May CPI inflation surprise

The CPI inflation for May positively surprised, coming down below expectations.

• The May headline CPI was flat MoM, at 0%, below the 0.1% MoM expectations.
• The May core CPI was up only 0.16% or 0.2% rounded, below the 0.3 expectations.

Both of these inflation measures indicate that the CPI inflation is moderating sharply, which is great news for the soft-landing believers. Given these low inflation readings, which are consistent with the Fed’s annualized target, increase the possibility that the Fed will cut interest rates, before the economy slips into a recession.

Of course, the May CPI is only a one-month reading, and obviously, the June and July CPI readings would have to confirm May’s readings – both months would have to come at 0.2% for the Fed to consider cutting interest rates in September.

So, is the May CPI inflation reading an indication of moderating inflation, consistent with the Fed’s 2% target, or the May’s CPI inflation is just an outlier?

What pushed inflation down in May?

First, it’s important to understand what pushed inflation down in May.

The headline CPI was pushed lower by falling energy prices.

Overall energy was down by 2% in May, led by a 3.6% fall in the price of gasoline. So, what pushed the price of gasoline down? The crude oil fell due to the de-escalation in the Middle East geopolitical situation, which was brokered by the Biden administration. Obviously, this is an election year, and inflation is one of the main issues, and the Biden administration will do all it can to push oil down. But is this sustainable? Nothing is really solved in the Middle East, and the situation with Russia is actually escalating.

The initial reaction to the May CPI data was higher crude oil prices by over 1%. Why? The premature Fed cut could boost the global economy, and push the USD lower, and both would push oil higher. Thus, don’t expect that energy prices will be falling over the next few months.

Also, it’s important to note that food away from home increased by 0.4% in May, above the 0.3% increase in April. This is the story that we hear about expensive fast-food prices, due to higher wages and cost of inputs. This inflation story is still active.

The core CPI was pushed down by falling transportation services

The core CPI was pushed down by falling transportation costs by -0.5%, as the cost of insurance suddenly decreased in May, while it increased by 0.9% in April. Higher car insurance prices are mainly due to more technologically advanced cars, which are more expensive to fix, so there is no reason to expect that this trend would change.

Note, the shelter inflation was still up by 0.4% in May, and there was no improvement over April’s reading. Shelter inflation is still high due to rising housing prices; thus, there is no reason to expect that shelter inflation will moderate over the next few months.

The May CPI inflation is an outlier

Thus, it appears that the May CPI is an outlier, caused primarily by temporary falling energy prices, as the US approaches the election, and a temporary decline in auto insurance prices.

But what do we know about inflation? First, we know that wages went up by 0.4% in May, and this is inflationary. But rather than looking at the government data, let’s see what consumers and businesses say about inflation in surveys.

The Michigan Sentiment Final for May says that consumers believe that inflation will be higher a year from now at 3.3%, which is the highest in six months, and well above the 3% number in April.

Inflation expectations for the year-ahead increased less than initially anticipated to 3.3% from 3.5% in the preliminary estimate, but remained the highest in six months.

The managers say in the May ISM Manufacturing survey that prices are still rising, with the reading of 57, well above the neutral of 50, but still slightly lower than 60.9 in April.

prices rose at a slower pace as most commodity driven costs continue to climb but at weaker rates

The managers in the May ISM Services PMI survey also say that prices are rising, with a high reading of 58.1.

the majority of respondents indicate that inflation and the current interest rates are an impediment to improving business conditions

The managers in the S&P Global US Manufacturing PMI survey say that cost inflation quickened to the fastest in just over a year.

On the price front, the rate of input cost inflation quickened to the fastest in just over a year, with firms raising their selling prices in response

The managers in the S&P Global US Services PMI survey warn about wages.

higher staff costs were again the key factor behind a sharp rise in overall input prices as wages were increased. The pace of input cost inflation quickened and firms raised their charges at a solid pace.

The S&P Global US Composite PMI survey says:

Input costs and selling price inflation both accelerated

The NFIB Small Business Optimism Index says that inflation has not eased much.

Small business owners need relief as inflation has not eased much on Main Street…a net 28% plan price hikes in May, up two points from April

Thus, managers and consumers warn that inflation is still a major problem, and this confirms that the May CPI inflation reading is possibly an outlier.

Implications

The initial reaction to the CPI data was 1) lower interest rates in expectations of Fed cuts, possibly in September (SHY), 2) weaker USD dollar (UUP), 3) higher commodity prices (GLD) (USO), 4) higher stock prices, particularly the tech stocks (QQQ), and the biggest reaction was a sharply higher Bitcoin (BTC-USD), up over 4%.

The Fed acknowledged in the June FOMC statement that the progress in inflation has been modest, but indicated only one interest rate cut in 2024. This confirms that the Fed also views the May CPI report as an outlier.

The S&P500 (SP500) is trading at PE ratio well above 23, and the Fed seems to be still at the higher-for-longer policy, which is essentially a higher-until-recession policy – despite the May CPI report. Thus, the S&P500 is facing a recessionary bear market. Of course, all eyes are now on June CPI.