But the June reports substantially weaken the argument that inflation is becoming embedded throughout the economy. And it reduces the immediate pressure on the Fed to raise interest rates.
Investors responded positively. The S&P 500 closed yesterday up approximately 0.4%, while the technology-heavy NASDAQ Composite gained 0.9%. Both indices were higher again today in mid-day trading.
Bond yields declined as well. One-Year Treasury yields are now approximately 0.15% lower relative to where they were prior to the reports, signaling significantly diminished expectations of a rate hike in the next year.
Long-term investors are justified in viewing these inflation reports with cautious optimism.
Many of the short-term inflation pressures associated with the recent energy shock have already made their way into consumer prices and are now beginning to ease.
Meanwhile, other inflation components that are generally unrelated to energy costs—particularly shelter—are showing clear signs of responding to several years of restrictive monetary policy.
Going forward, the economy also stands to benefit from the disinflationary impact of stronger productivity growth.
Warsh devoted a significant portion of his testimony yesterday to this possibility. He described AI as perhaps the most important economic transformation of his adult lifetime and said the United States is likely to be a major beneficiary.
He also made clear that the Fed should not respond to faster productivity-driven growth by automatically trying to restrain the economy, reiterating that the Fed under his leadership will not be “afraid of productivity-led growth.”
This is an important departure from the idea that strong economic growth must necessarily produce higher inflation.
If AI, automation, infrastructure investment, and other technological improvements allow the economy to produce more goods and services with the same amount of labor and capital, faster growth can coexist with more subdued price increases.
At the same time, Warsh remains firmly committed to the Fed’s 2% inflation goal and the objective of making the inflation surge of recent years “a thing of the past.”
Inflation trends tend to move in long waves. If we are indeed transitioning into a new environment of more subdued inflation, it could ultimately pave the way for substantially less restrictive monetary policy.
That would benefit most asset classes.
In addition to stocks and bonds, this includes “debasement trade” assets like gold and crypto. Both are highly sensitive to perceived changes in monetary policy and have moved higher since the report. Gold is trading modestly higher, while Bitcoin has risen close to 5%.
Behind the inflation numbers
The sharp decline in headline inflation was largely driven by lower gasoline prices. But there was more good news in the CPI report beyond energy: core prices were unchanged, shelter inflation slowed dramatically, and several categories that have been stubborn sources of inflation moved lower.
In other words, this was not merely a favorable energy report. It was a genuinely encouraging inflation report.
CPI fell 0.4% in June, compared with expectations for a decline of only 0.1%. This was the largest monthly decline since April 2020.
On a year-over-year basis, headline inflation dropped to 3.5% from 4.2% in May. Economists had expected a reading of approximately 3.8% to 3.9%.
The energy index fell 5.7%, reversing part of the sharp increase recorded during the previous three months. Gasoline prices dropped 9.7%, while electricity prices declined 1.0%.
These declines reflected the temporary retreat in oil prices that followed the ceasefire between the United States and Iran. That ceasefire has since broken down, suggesting that some of June’s energy-related improvement could reverse in July.
Yet even after the June decline, energy prices remain 15.7% higher than they were one year ago, while gasoline prices are up 26.7%. The energy component remains a disinflationary tailwind, even given the more recent movement higher.
Core CPI, which excludes food and energy, was flat in June. Economists had expected a 0.2% increase. The year-over-year core inflation rate fell to 2.6% from 2.9%.
Core inflation over the last three months has been running at an annualized rate of approximately 2.4%. That is much closer to a normal inflation environment than the alarming readings investors encountered during the spring.
Shelter is key
The most important detail in the report may have been shelter.
Shelter prices increased only 0.1% in June, the smallest monthly increase since January 2021. Actual rents rose 0.1%, while owners’ equivalent rent increased 0.2%. Lodging away from home fell 2.3%.
Shelter represents more than one-third of the CPI and has been one of the largest obstacles preventing inflation from returning to normal.
Because the CPI’s housing measurements respond slowly to changes in current market rents, economists have been anticipating a slowdown for some time. June finally delivered a meaningful one.
If shelter costs continue increasing at anything close to June’s pace, broader core inflation could continue moving lower even if gasoline and other volatile categories rebound.
Breathing room for the Fed
The Fed cannot ignore the possibility that renewed energy inflation will eventually spill into transportation, manufacturing, food, and other parts of the economy. But the June report indicates that this process is not occurring on a broad scale.
Markets responded by sharply reducing expectations for near-term Fed tightening. The implied probability of an interest-rate increase at the July meeting fell from nearly 42% to less than 13%.
This is not an environment in which the Fed is likely to rush toward rate cuts. Headline inflation is still too high, and policymakers will remain cautious.
But the burden of proof has shifted.
Many investors were concerned that another hot inflation reading could make a July or September rate increase increasingly difficult to avoid. Instead, they received evidence that underlying inflation is moderating even as economic growth remains resilient.
That combination—solid growth, improving core inflation, stronger productivity and a Fed that can remain on hold—is favorable for risk assets generally, especially ones that are highly sensitive to the trajectory of interest rates.
Meanwhile, corporate earnings growth remains strong.
With moderating inflation setting the stage for less restrictive monetary policy going forward, the macro environment continues to look attractive to us—even as investors fret over geopolitical and AI-related risks, which helps keep valuations in check.
