Tuesday’s inflation report will be crucial to the Fed’s policy direction

Inflation data released in May will show that price increases that have been troubling consumers over the past two years are slowing.

However, the question will be whether this slowdown will be enough to convince Fed officials that they can hold off on raising interest rates and let the US economy breathe on its own for a while.

The Consumer Price Index, due for release Tuesday morning at 8:30 ET, is expected to show that inflation for all items rose just 0.1% last month, equaling a 4% annual rate, according to the Dow Jones consensus estimate. Excluding the volatile food and energy components, CPI is expected to increase by 0.4% and 5.3%, respectively.

These kinds of numbers may encourage policymakers that inflation is heading in the right direction, having peaked above 9% in June 2022.

“The most encouraging thing is that annual growth rates are going to come down very sharply,” said Mark Zandi, chief economist at Moody’s Analytics. “The headline number will feel good, it will be encouraging, it will show that inflation is moving in the right direction. More importantly, I think inflation is He is moving in the right direction.”

Indeed, inflation has come a long way since it started picking up in the spring of 2021. Pandemic-related factors such as clogged supply chains and huge demands for goods for services combined with trillions in monetary and fiscal stimulus to send inflation to the highest level since the early 1980s. .

After a year of insisting that inflation would not last, the Fed began in March 2022 what could be a series of 10 interest rate increases. Since then, inflation has been gradually declining, but it is still far from the central bank’s target of 2%.

Tuesday’s report should be enough to convince FOMC policymakers to skip a rate hike this meeting as they wait for incoming data and decide the longer-term policy path.

“Inflation is coming and they might get a number to comfort them that things are going in the right direction,” Zandi said. “They don’t need to raise interest rates again.”

There will be several key variables to watch in the May CPI report.

One of them will be an anomaly: core inflation will likely look much stronger than the headline, an unusual occurrence in that the former takes into account fewer variables and excludes food and energy, which tend to be hotter. This discrepancy is largely the result of year-over-year comparisons that would necessitate a period when gasoline was on its way to more than $5 a gallon at the pump, a condition that has since subsided.

Other parts of the report worth looking closely at are used car prices, which jumped 4.4% month over month in April and are expected to be strong again in May. Shelter costs make up about a third of the CPI weighting, but Fed officials are counting on them to roll back later this year. Economists are also looking for airfare and housing costs to rise in May.

“Inflation was trending downward last year,” said Dean Baker, co-founder of the Center for Economics and Policy Research. “If this trend continues, the Fed can declare victory and focus on the employment side of its mandate. However, inflation remains well above average. [2%] The goal, so the question is whether the downward trajectory continues or whether we have reached a plateau.”

While market expectations are for the Fed to skip this meeting, there will likely be one last hike in July before an extended pause that is now expected to last into the first part of 2024, according to the Federal Reserve. CME group scale Trading in the federal funds futures market.

The CPI report, as well as other monthly data ahead of the Federal Reserve meeting on July 25-26, can go a long way in determining whether the market is correct or if officials decide they have more work to do.

“Whether or not they can have a soft landing depends in large part on how inflation happens,” said Bill English, a former Federal Reserve official who is now a professor of finance at Yale School of Management. “If inflation stays high, they should just raise rates more. A path to employment and production that corresponds to getting inflation down to 2% in two years may not be the way you want it to be.”