E-piphany

While the worst is probably over for the monthly CPI prints, the real question going forward is ‘how much better does it get?’ We know that energy prices will eventually retreat, but even if they merely flatline they will stop flattering headline CPI. But where does core and more importantly median CPI settle in? That’s the real question. For now, we just have one more month of data so let’s dig in.

The economist surveys had CPI at +0.51% headline and +0.27% core. The inflation swaps market was in roughly the same place, with +0.66% NSA the last trade.

The last month has seen a lot of volatility in markets (duh), but in particular a significant increase in real yields.

Nominal yields have risen a bit, and get all the ink when 30-year yields peek above 5%. That actually masks the real problem, which is that nominal yields have risen so little only due to the sharp decline in inflation expectations. In the front of the curve, that decline in breakevens is significantly a carry phenomenon (as we roll through months with solid NSA accretion) and so, therefore, is some of the rise in real yields. But a 40bps increase in real yields at the 5-year point gets one’s attention. And at 2.17%, 10-year real yields are near the absolute highs they’ve seen since the Lehman-related spike over 3% in 2008.

(Oh, and if any technician tells me this is a ‘flag’ formation projecting to 5%, I’m going to smack you. Real yields don’t go to 5%.)

The uptrend in real yields, as an aside, has also been bad for gold. Gold behaves like a long duration TIPS bond and as TIPS have sold off, gold has been a whipping boy. That won’t last forever. I like buying 10-year TIPS anywhere north of 2%, and if real yields get above 3% some day – back up the truck. Let’s hope that isn’t soon though.

---

The actual data comes in today at +0.473% m/m on headline CPI and +0.208% on core CPI. Both of those are below expectations, with core a meaningful miss. Here are the last 12 core CPI figures (keep in mind that last month’s jump was a payback for the 6-months-ago quirk in rents due to the government shutdown).

And here are the m/m, y/y, and prior y/y for 8 major subgroups. It’s striking that Apparel is +4.8% and “Other” is +4.9%. Those are not usually exciting categories! I’ll return to this a little later.

Here is the coarse breakdown of core goods (+1.06% y/y) and core services (+3.42%).

It isn’t surprising that core goods is decelerating. It’s actually somewhat concerning that it isn’t decelerating faster. The hook higher in core services bears some further investigation. Even though the overall numbers looked good this month, this breakdown isn’t all sunshine and roses.

Primary rents were +0.36% m/m, and 2.92% y/y versus 2.79% last month. OER was +0.3% m/m, 3.32% y/y. The jump in Rent of Primary Residence is a little concerning (although I will note that it puts the actual y/y number exactly on our model, which goes pretty flat near this level for the next year). Last month’s hook higher made sense because of that make-up month due to the shutdown/6-month lag effect. But that isn’t the issue here. Lodging Away from Home was alto +0.4% m/m, 5.2% y/y. Some people will say this is a World Cup effect, and possibly we are seeing a little bit of that in Lodging Away from Home. But this isn’t France. The US is a pretty huge country and there is no way that World Cup tourism is enough to move rents for the entire country.

But landlords are seeing higher direct and indirect costs. This is why rents are not going to go into broad deflation any time soon.

What might also be flagged as a World Cup effect, but more likely is just jet fuel pass-through, is the 2.69% m/m rise in Airfares after a 2.82% rise last month. I have airfares just slightly above the model given jet fuel prices, and within the error bars, so if there’s an impact there it’s pretty small. I think this is worse in Europe. Airfares are indeed part of the story in the core-services move higher that I noted above. Rents are too, but the airfares increase is easier to figure out.

The median category this month looks like Recreation at 3.51% annualized m/m. I may be slightly low, depending on where the regional rent indices get adjusted, but my guess for Median CPI is +0.287% m/m for a small acceleration y/y to 2.83%.

I have to say – if you shovel some of April’s jump back into October and November where it belongs – it still doesn’t look like deceleration to me.

Okay, here are the four pieces charts. Food & Energy +9.81% y/y. Core Commodities +1.06% y/y. Supercore +3.55% y/y. Rent of Shelter +3.33% y/y

The Core Services less Rent-of-Shelter (Supercore) is the one I don’t like, but again part of that is the Airfares/energy thing. None of this looks like super good news, though.

By the way, there were only 3 categories that declined at a faster annualized rate than 10% this month: Car and Truck Rental (weird) at -40% annualized, Motor Vehicle Insurance (very weird) -18%, and Misc Personal Goods -11%. Above 10%, and ignoring food and energy, we have Jewelry/Watches (41%), Misc Personal Services (28%), Communication (17%), Tobacco and Smoking Products (+13%), Infants/Toddlers Apparel (+12%). Motor Vehicle Maintenance and Repair just missed the cut at +9.95% annualized.

Here are a couple of interesting things I’m watching. This chart is Computer Software and Accessories, and it’s where AI tools land. Now, it’s a tiny, tiny part of the basket at the moment but I’ll bet it’s larger when they reweight next year. This is the NSA price index, not the rate of change – so prices for computer software and accessories are higher than they’ve been for years.

Like I said, this is a tiny category but it actually matters more for PCE. That fact annoys the Fed, who just published a research piece (https://www.federalreserve.gov/econres/notes/feds-notes/measurement-of-computer-software-and-accessories-inflation-20260522.html) explaining that this is partly ‘measurement error.’ Uh-huh. Boy are we getting picky.

Also, I happened to notice that computer prices are actually increasing, due to upward pressure on DRAM and other component prices thanks to AI demand. This sort of annoys me because I need a new laptop and the prices aren’t going down like they usually do if you wait. And yes, that’s the main reason I noticed.

This is one of those categories that animates conspiracy theorists because the BLS hedonically adjusts it…so since computers are always improving, there’s a general decline in the quality-adjusted-price over time. Well, not just a general decline, but a pretty large decline. “But computer prices haven’t actually fallen! Yes I get more computer but I don’t have the option to get the old one! I want my Windows 95!”

So prices going up, at least if it continues, is interesting. It’s a symptom of AI demand. It’s still not a large part of CPI, but I think AI is going to start showing up more here and there. Like here:

This is obviously not all AI – the upswing happened in the aftermath of COVID, possibly partly because work from home means power needs are broader throughout the day. But the continuation recently…I am pretty sure AI data center demand, if it isn’t yet affecting this, is going to!

And that is emblematic of the long-term story here. Not this month’s story per se. But these upstream pressures on petroleum and electricity are passing through more and more downstream. And that’s a hard dynamic to arrest. It is difficult to put that genie back in the bottle.

Now, this isn’t to say there is no good news.

This is Medicinal Drugs, aka pharmaceuticals, in core goods. It was -0.8% this month after -0.3% last month, and is -2.2% y/y. This looks like a real TrumpRX effect. On the other hand, Hospital Services is still rising at about 6% y/y, so while overall Medical Care in the CPI is +2.6% y/y, that’s being flattered because of the TrumpRX effect which won’t last forever.

Now, earlier I pointed out Apparel’s interesting y/y increase. The absolute price of apparel basically peaked in 1993 or so. This is a wonderful picture of the power of offshoring, as we went from producing a lot of apparel domestically to producing basically nothing, and saw apparel prices decline in real terms and even in outright terms for nearly 30 years. There was a sharp dip and recovery due to COVID, but in the last year or so the Apparel index has actually gone to new all-time highs.

Some of that is re-onshoring. Some right now is actually petroleum since many types of fibers are downstream petroleum byproducts. Think polyester, but it’s broader than that. But prices prior to the energy spike were already at 20-year highs.

The bottom line here is that the rise in the headline CPI is causing some people to shrilly declare that the Fed needs to raise rates. That’s ridiculous – the Fed looks through energy price increases. Although as I said before, those energy price increases, if they are sustained long enough, start to percolate through, and they appear to be…core and median and trimmed mean CPI won’t be heading back to target (not that there is a target any more) any time soon. As long as the economy stays pretty strong, the Fed has actually stumbled into what should be a comfortable spot for a while. Warsh will work on trimming the balance sheet, hopefully, but I wouldn’t expect rate changes for a while and that’s a change in my view from before when I thought the Fed would be easing (I thought growth would be weaker and I continue to be confounded on that). I’m saying that while the headline inflation data look ugly, that will pass as energy prices decline. But I do think it will be difficult for the Fed to get comfortable with Median CPI going back up, or just not going back down, while growth is strong.

“Mike, Mike, Mike…you’re making too much of these little things! Core doesn’t look too bad. Median is not alarming.”

Yes. But electricity, petroleum, the demographic pivot, re-onshoring, and let’s not forget money growth. These are not small things and they affect how difficult the future looks with respect to inflation. The tree’s leaves are pretty but the trunk is rotten. I am not optimistic about future shade.