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July PPI Declines As Energy Falls, But Fed’s Inflation Challenge Remains

Today the Producer Price Index (PPI) told a similar story to yesterday’s CPI data. Inflation has moved sharply lower in July. In the case of the PPI, prices actually declined 0.5% for July when compared to June.

This brings a welcome break from a string of price increases throughout 2022’s monthly PPI reports. Of course, given the recent run-up and despite July’s decline, PPI prices remain up almost 10% year-over-year.

July’s price decline is mostly due to falling energy costs which are down 9% for the month. Once those are stripped out, underlying inflation may remain at a higher level than the Fed wants to see. Excluding food and energy costs for July prices rose 0.2% translating to a 2.4% annualized inflation rate, slightly ahead of the Fed’s inflation goal but much better than many recent months.

Still, it is clearly encouraging that inflation has moved lower for July. Assuming energy pricing doesn’t spike from here, it seems likely that peak U.S. inflation is behind us.

Also, even without energy there are encouraging trends, such as services prices trending lower. Services prices are often less impacted by commodity price swings and are perhaps a better measure of underlying inflation in the economy.

Food Costs Still Rising

As with yesterday’s CPI data, one obvious concern is food price inflation. With food costs up 1% for July in the PPI index. Food is a major cost, especially for lower income households. However, even if food costs do continue to spike, inflation may trend lower from here.

A Question For The Fed

The Fed has an interesting challenge ahead. Even if inflation is trending lower from here, as seems likely, the question is – when inflation is low enough?

The Fed has a 2% target for inflation. Of course, we’re currently well ahead of that because of the run up in prices. The Fed doesn’t want to end its inflation battle too soon, but its also worried about pushing the U.S. into recession as many indicators suggest is a strong possibility.

Looking forward the Fed will need to estimate where inflation is going in setting interest rates. To make sure that inflation really is trending back to their 2% target. A single month of price data is unlikely to offer sufficient confidence, though it is encouraging.

Today’s PPI report is welcome news, but inflation forecasting remains a complex problem. The markets think the Fed will start to moderate rate increases slightly at their September meeting, but rates are still certainly expected to move up. The most likely outcome according to futures markets is that the Fed raises rates 50bps, with an outside chance of a 75bps hike. That’s still a big move, but it’s a probably step down from the very large moves we’ve seen at recent meetings.

Today’s PPI data offers further evidence that we have likely passed peak U.S. inflation. However, whether the recent moves up in interest rates together with declines in commodity prices have done enough to take inflation back to the Fed’s 2% target remains to be seen. The markets still think the Fed has some work to do and will continue to raise rates for the remaining Fed meetings of 2022. However, perhaps some of the steeper rate hike scenarios are now less likely as inflation appears somewhat tamed.