U.S. Inflation Slowed In May With Increase Of 0.1%

Includes: TIP
by: Tipswatch

Both headline and core inflation numbers fell short of consensus estimates.

Gasoline prices fell 0.5% in May, following a 5.7% increase in April. Gas prices could be a deflationary force in coming months.

May's mild inflation report leaves the door wide open for the Federal Reserve to begin cuts in short-term interest rates.

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.1% in May on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, "headline" inflation increased 1.8%.

May's monthly increase matched the consensus forecast of 0.1%, but the 12-month number dipped slightly below the forecast of 1.9%. Core inflation, which removes food and energy, also increased 0.1% in May, below the forecast of 0.2%. Core inflation is up 2.0% over the last 12 months, also below the forecast of 2.1%.

This report looks like good news for the stock and bond markets, because it reinforces the Federal Reserve's likely plan to begin lowering short-term interest rates, possibly twice in 2019. The first cut could come next week, or possibly in July.

As this chart shows, both headline and core inflation have been gradually trending downward in the last 12 months. This trend is likely to continue with recent strong declines in oil and gasoline prices, which weren't fully reflected in the May report.

12-month U.S. inflation But energy prices did contribute to lower inflation in May. The energy index fell 0.6%, following a 5.6% decline in April. Before seasonal adjustment, gasoline prices rose 2.4 percent in May, but seasonal adjustment placed gas prices down 0.5% for the month and 0.2% over the last 12 months. You can expect gasoline prices to be a drag on inflation numbers over the next few months.

Food is one area seeing price increases, with costs up 0.3% in May and up 2.0% over 12 months. The BLS said the food index accounted for nearly half of the May increase in headline inflation.

Another significant inflationary trend is the cost of shelter, which was up 0.2% in May and 3.3% over the last 12 months. In addition, the costs of medical care services rose 0.5% in May and are up 2.8% over 12 months.

Apparel costs, however, have fallen 3.1% over the last 12 months.

What this means for TIPS and I Bonds

Investors in Treasury Inflation-Protected Securities and U.S. Series I Savings Bonds are also interested in non-seasonally adjusted inflation, which is used to adjust principal balances on TIPS and set future interest rates on I Bonds. The BLS set the May inflation index at 256.092, an increase of 0.21% over the April number.

For TIPS. The May report means principal balances for all TIPS will increase by 0.21% in July, continuing a string of increases: 0.42% in April, 0.56% in May and 0.53% in June. However these out-sized numbers (compared to seasonally adjusted inflation) will eventually reverse themselves and balance out over 12 months. Here are the new July inflation indexes for all TIPS.

For I Bonds. The May inflation report is the second in a series of six that will set the I Bond's new inflation-adjusted variable rate, which will be reset on November 1. Through two months, inflation has increased 0.74%, which translates to a variable rate of 1.48%, already higher than the current rate of 1.40%. Here are the numbers:

I Bonds and Inflation Keep in mind, however, that the recent drop in gasoline prices is likely to result in some near-deflationary CPI reports in the short term. Last summer, non-seasonally adjusted inflation slowed dramatically, to 0.01% in July and 0.06% in August. We may see a similar slowdown in 2019.

What this means for future interest rates

There's nothing in the May inflation report to give the Federal Reserve pause over gradually paring short-term interest rates. The markets are expecting a 75-basis-point drop in the Federal Funds Rate over the next 18 months. The only question is: When will the cutting begin?

From this morning's Wall Street Journal report, which noted that inflation-adjusted wages were up 1.3% for American workers over the last year:

The report is an indication that inflation pressures remain muted despite a strong labor market that is starting to deliver wage gains for workers. ... But some policy makers have started contemplating cutting interest rates if inflation remains persistently weak. In May, Fed vice chairman Richard Clarida suggested the Fed could cut interest rates “if the incoming data were to show a persistent shortfall in inflation below our 2% objective.”

My expectation is that Federal Reserve can use next week's meeting of its Open Market Committee to signal future rate cuts, and then follow through in July with a 0.25% cut in the Federal Funds Rate.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he recommends can purchased through the Treasury or other providers without fees, commissions or carrying charges.