Missing expectations, headline and core CPI extended the recent deceleration of year-over-year trends. Today’s softening performance may color today’s FOMC policy statement and impact outlook projections.

Energy Weighs on the Headline

Following a 0.2 percent rise in April, the headline Consumer Price Index (CPI) missed expectations, slipping 0.1 percent in May – the second decline in three months. The primary driver of the headline’s decline was a 2.7 percent contraction in energy prices, as a 6.4 percent drop in gasoline prices more than offset gains in electricity and natural gas (0.3 percent and 1.9 percent, respectively). Consumer food prices increased for the fifth consecutive month, up 0.2 percent.

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Excluding food and energy, core CPI came in tamer than expected, rising just 0.1 percent on the month. Shelter costs increased 0.2 percent in May as the rent index and the index for owners’ equivalent rent both advanced by a similar amount. This monthly performance was lower than that seen in April, but still keeps the year-over-year pace of shelter costs elevated above 3 percent. Several sectors within the core CPI contracted, tempering the aforementioned gains. Apparel dropped 0.8 percent, its third consecutive monthly decline, while airline fares, motor vehicles, communication and medical care services also posted lower readings. Medical care, education and recreation were all flat on the month.

Collectively, the trend of weakness in the core CPI continues. This is clearly evident in the three-month annualized pace which fell to a zero reading from 0.6 percent in April and a 3.0 percent pace in February. As seen in the middle chart, this deteriorating performance suggests that the annual pace of core CPI could continue to fall below its current two-year low of 1.7 percent in the coming months.

Still Enough for the Fed?

No doubt, the performance of consumer inflation has been soft relative to expectations at the start of the year. Year-over-year rates of headline and core CPI inflation have pulled back substantially in recent months, raising concerns over the likelihood of reaching the Fed’s 2.0 percent target (note, the Fed’s preferred measure of consumer inflation is the PCE deflator). Coming into today’s CPI report and the June FOMC meeting, most Fed officials have characterized the softening inflation performance as "transitory." Interest will be high as to whether this assessment continues in the updated policy statement and with officials’ inflation outlook. There is certainly now a higher probability that the Fed may include more dovish language in the policy statement over the current inflation performance as well as trim its inflation projections. A 25 bps federal funds rate hike is still expected at the conclusion of today’s FOMC meeting, but clearly officials will be mindful of incoming inflation trends in the coming months before greater confidence can be made with second half of the year policy normalization plans.

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