This Week's State Of The Economy - What Is Ahead? - 11 August 2023

By: Taro Chellaram /Wells Fargo Economics & Financial Report/Aug 15, 2023

This Week's State Of The Economy - What Is Ahead? - 11 August 2023

Inflation was in the spotlight this week. During July, both the headline and core measures of the Consumer Price Index (CPI) rose 0.2%. These monthly gains were largely in line with consensus expectations and provided additional evidence that price pressures are still receding. Inflation's descent, however, continues to be gradual. On a year-over-year basis, the core CPI was up 4.7% in July. Recent signs have been more encouraging. The recent string of lower core CPI prints has pushed down the three-month annualized pace to 3.1%, the lowest since September 2021. The downshift in inflation without a material deterioration in economic growth has raised the likelihood of a soft landing, a topic we cover in more detail in our macroeconomic forecast update for August.

That said, by most measures, inflation is still above the Fed's 2% target and the path from here is anything but certain. There is a bit more clarity on the trajectory of shelter costs, which have been a substantial driver of overall inflation over the past year. The pace of shelter inflation has eased in recent months, yet it still is running at a hot rate. Primary shelter inflation, which largely reflect apartment rents, rose 0.4% during July. The CPI's measure of shelter prices tends to significantly lag private measures, which have shown a considerable downshift in rent growth. In addition, apartment demand has been more modest recently, and the pipeline of new apartment construction continues to run at a near-record pace. Together, these factors point to a further moderation in shelter costs in the near term.

Outside of the heavily weighted shelter component, services price changes were mixed in July. Airfares and vehicle rental prices both declined during the month. Medical services inflation softened during the month, while motor vehicle insurance, recreation services and tuition and childcare all rose. All told, core services inflation picked up 0.4% during the month, a more temperate rate compared to earlier in the year, but a mild acceleration relative to June.The climbdown in inflation continues to be aided by smoother functioning supply chains and normalizing demand. Core goods prices dropped 0.3% in July, the largest drop since March 2022. Prices for new and used autos fell during the month. Declines in household furnishings, recreation goods, education and communication goods also contributed to the downdraft.

Evidence that underlying inflation pressures are not intensifying was presented elsewhere this week. The core Producer Price Index (PPI), which excludes volatile food and energy costs, increased 0.3% during July, a tad higher than market expectations. However, over the past year, the core PPI was up 2.4%, similar to June's annual change. Cost pressures also appear to be diminishing for small business owners. Small business optimism bested expectations in July, notching its third consecutive improvement to reach an index reading of 91.9. Small business confidence is still low but has brightened recently alongside more moderate inflation. Consequently, fewer firms are reporting the need to implement price hikes. The net percentage of firms raising prices over the past three months fell to 25%, its lowest level since February 2021.

Inflation expectations also remain well-anchored, at least according to the preliminary results for the University of Michigan's Consumer Sentiment index for August. The top-line sentiment index came in at a reading of 71.2, down slightly from July's reading. The slip in sentiment was in line with consensus estimates and occurred against a backdrop of rising gas prices, announcement of a U.S. debt rating downgrade and ongoing financial market volatility. The inflation expectations components were more encouraging. One-year inflation expectations eased to 3.3% during the survey period, while 5-10 year inflation expectations slipped to 2.9%. Consumers continuing to not anticipate a sharp run-up in prices in the future will come as welcome news to policymakers and bolsters our view that July's 25 bps fed funds rate hike was the last of this tightening cycle. Inflation continues to ease; however, it still remains above target. Until price pressures are convincingly set on a course for 2%, rate cuts still look to be off in the distance.

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