The U.S. Consumer Price Index (CPI) for July met market expectations. Following a significant weakening of inflation data in June, the overall CPI rose by 0.1% month-over-month in July, while the core CPI, which excludes food and energy, increased by 0.2%. As a result, the year-over-year headline inflation rate fell from 3.5% to 3.4%, and core inflation dropped from 2.6% to 2.5%. When converted to a three-month annualized core inflation rate, it currently stands at just 1.6%. The combination of weak nonfarm payroll data from last Friday and this latest inflation downturn has sharply reduced the willingness of hawkish Federal Reserve officials to raise interest rates.
However, with the next Federal Open Market Committee (FOMC) meeting scheduled for September 16, the market will still confront new rounds of employment and inflation data, as well as the Jackson Hole global central bank symposium. Therefore, this single data point is unlikely to trigger significant market volatility. Breaking down the components: gasoline prices fell by 2.9% month-over-month; the housing component of inflation slowed significantly, rising by only 0.1% month-over-month; and prices for food, clothing, new vehicles, and other goods and services all increased by a modest 0.1%, indicating very stable price trends. Used cars and medical services rose by 0.4% month-over-month, and education services increased by 0.6%, making them the primary categories for price increases. However, these sectors all saw price declines in June, suggesting overall price pressures are manageable. The only notable price increase was in airfares, which rose by 2.2% month-over-month and surged 25.5% year-over-year, primarily driven by higher jet fuel costs. If a resolution to the Middle East conflict is reached, causing oil prices to fall, airfares could quickly adjust downward.
Based on the comprehensive data, we maintain our previous assessment: the Federal Reserve will begin a long-term cycle of waiting before cutting rates, and the current interest rate stability could persist until 2027. The chart below displays core CPI under different measurement methodologies: the black line represents a monthly increase of 0.17%. Only if core CPI monthly increases consistently average this level over the long term can the year-over-year inflation rate gradually decline to the 2% target.
Four Key Support Factors for Core Inflation Indicators: Inflation Will Continue to Cool Until 2027
1. Gasoline prices continue to exert downward pressure on headline inflation. The current international oil price is around $83 per barrel, which corresponds to a reasonable U.S. gasoline retail price range of $3.8 per gallon. However, the American Automobile Association (AAA) reports a market average price of $4 per gallon, a premium driven by temporarily high refining margins. If shipping in the Strait of Hormuz resumes and crude oil supply flows freely, refining margins will narrow, leading to lower gasoline retail prices, which will persistently drag down headline inflation.
2. The housing component, which carries the highest weight, will continue to pull inflation lower. Housing accounts for up to 35% of the CPI basket of goods and services, with a current year-over-year increase of 3.2%. High home prices combined with high mortgage rates have significantly weakened purchasing power, and current home sales volumes have fallen to levels reminiscent of the post-2008-2012 global financial crisis slump. Data shows national home price appreciation is only 1%, and an increasing number of states are seeing rental prices decline. We expect that over the next 12 months, this highest-weight housing component will keep suppressing headline inflation.
3. Labor costs are cooling, and the pressure from wage-driven inflation is receding. The largest cost for businesses is not technology inputs, tariffs, or energy, but the cost of labor. In 2022, the ratio of unemployed persons to job openings in the U.S. was 1:2, indicating a severe labor shortage. Now, supply and demand are largely balanced, and the wage inflation bubble has significantly deflated. Furthermore, the quits rate, a key measure of labor market fluidity, has dropped sharply, meaning businesses no longer need to offer large wage increases to retain employees. The Employment Cost Index shows that private sector wages are rising at a year-over-year rate of only 3.1%, which is consistent with average hourly earnings growth. This wage growth level is fully compatible with the 2% inflation target.
4. The price-increasing effects from tariffs are rapidly fading. The imposition of tariffs only causes a one-time increase in prices, which is a temporary shock. With the current U.S. tariff policy being relaxed and the number of exemption clauses significantly increasing, the upward pressure on inflation from tariffs will dissipate quickly. The "Liberation Day" tariffs under the now-overturned International Emergency Economic Powers Act, as per a Supreme Court ruling, have seen the Treasury Department refunding the relevant taxes to businesses. New tariff revenue generated in May has been completely offset by tariff refunds. In June, the total amount of tariff refunds by the Treasury Department exceeded the total tariff revenue collected for that period by $25.5 billion. With July data to be released later today, the scale of refunds is expected to grow further. This improves corporate cash flow, helping to offset cost increases in other areas and reinforcing the deflationary trend.
Concerns About "Chip Inflation" are Overblown
Market concerns that data center construction will drive up semiconductor demand, creating "chip inflation" and causing collective price increases for electronics like laptops, phones, and game consoles, are based on flawed logic. The computer and communication equipment category has a weight of only 0.7% in the CPI basket, far less than the 35% weight of housing. Moreover, this category uses hedonic pricing, where improvements in product quality are directly calculated as price reductions. Data shows that CPI prices for smartphones have fallen by 10.9% year-over-year, even though the base selling price of the products has not increased. Because features like cameras, battery life, and chip performance have all been upgraded, the same budget can now buy a higher-configured product, which is directly reflected as a price decline in the inflation statistics.
The Federal Reserve Will Maintain Interest Rates at Current Levels for an Extended Period
Over the past five years, the Fed has consistently failed to achieve its 2% inflation target, but the current trend of declining inflation is clear. Inflation expectations among consumers remain within a controllable range, and the recent energy price increases have not yet triggered a second wave of broad-based price increases. Furthermore, market-based inflation expectations are stable, with the 10-year breakeven inflation rate aligning with its 25-year average. While the market continues to bet on a rate cut by the Fed this year, we believe the Fed is more likely to hold the current interest rate for an extended period, and the wait-and-see cycle before cutting rates could last until 2027.
Comments