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Economic and Market Commentary

Data Underpinning CPI Report Suggest U.S. Inflation Moderated Materially in March

March inflation data may put the Federal Reserve close to its terminal policy rate this cycle, if it hasn’t already reached it.

Although core U.S. inflation rose 0.4% in March, details in the Consumer Price Index (CPI) report suggest that the level of underlying inflation is moderating materially. Notably, rental inflation decelerated and there were no signs that increased wholesale prices for used vehicles were being passed on to consumers.

Overall, the March CPI report reaffirms our view that the U.S. Federal Reserve is close to the end of its rate hiking cycle, and whether it hikes one more time at its May meeting is a close call. Recent comments from Fed officials, particularly from Chicago Fed President Austan Goolsbee, raised the prospect that the central bank holds steady in May. Supporting this view: slowing loan growth, likely due in part to banking sector stress, and several other indicators that suggest that the U.S. economy is decelerating. If Fed officials want to pause, the March CPI print as well as the likely-to-be-weak retail sales report (coming on Friday) could give them room to do so.

Key details in the inflation report: rent, cars, groceries

The main news from the March inflation report is that rents and owners’ equivalent rents (OER) both decelerated to 0.5% month-over-month (m/m, down from 0.76% and 0.7% m/m, respectively). This timing aligns with the typical lag between the high-frequency rental data, which peaked last year, and the pass-through to CPI. Still, we believe this is an important indicator that the disinflation Fed officials have been counting on is likely to continue. Fed officials have been focusing on inflation for services excluding shelter under the assumption that rental inflation would moderate, and the March report should give them some comfort that this is likely to happen.

The other news is that used car prices fell (−0.9% m/m) despite the recent reacceleration in wholesale used car auction prices. We had expected this given differences between the way CPI and the Manheim Used Vehicle Value Index measure used car prices. Specifically, the Manheim index can be affected by mix shift, i.e., a change in the relative index weights of different specific vehicle types, whereas the CPI does not embed mix shift. This difference in methodology suggested that the recent acceleration in the Manheim index would not be fully passed through to CPI; this happened last year as well. However, the price declines in the CPI report were larger than many observers expected. Meanwhile, new car prices continued to rise (0.55% m/m), a reflection of the persistent inventory problems across new and used vehicles in the U.S.

Food price inflation was flat in March. Idiosyncratic factors likely played a role: Egg prices fell 11% m/m after surging due to supply issues amid avian flu. However, softer prices across other categories of raw ingredients such as meats and fruit/vegetables suggest that weaker commodity prices may finally be passing through to consumers. Inflation for processed foods and for meals outside the home still appears sticky.

Core goods prices, excluding autos, were somewhat mixed in March, but remained generally firm. This is consistent with commentary from several retailers in the first quarter about improving inventory positions, which in turn provide more flexibility on discounting.

Core services inflation, excluding rents and OER, increased by 0.4% m/m. While this pace has decelerated somewhat, it still appears inconsistent with the Fed’s inflation target of 2% (as measured by personal consumption expenditures). Some of the strength in the March data came from the more volatile categories such as airfares (4% m/m) and hotels (3.1% m/m).

Inflation outlook

The March report brought the 3-month annualized pace of core CPI down to 5.1%, and year-over-year to 5.6%. While the pace of core CPI in the first quarter is still inconsistent with the Fed’s target, the apparent peak in shelter price inflation, aligning with our expectations, boosts our confidence (and likely the Fed’s as well) that core inflation will continue to decelerate – though we still expect core inflation to remain above the Fed’s target at year-end (for details on our forecasts, please see PIMCO’s latest Cyclical Outlook, “Fractured Markets, Strong Bonds”).

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