CPI rose to 8.6% in May as inflationary pressures continue to strengthen

Nearing the End of the Runway?

A record pace of CPI inflation raises the risk of above-neutral rate hikes by the Fed

The May release of the Consumer Price Index has raised concerns about a potential 2023 recession as CPI inflation reached a new high of 8.6% year-over-year. This upward jump exceeded consensus expectations of an 8.3% rise.

While there were several contributing factors, the most concerning is that this is the second straight month and the fifth time in eight months that we have seen a 0.6% increase in core CPI inflation. To put this in context, the average monthly gain in the five-year period from 2015 through February of 2020 was 0.2%.

Another hot summer

In the early summer of 2021, new and used car prices, as well as airfare, were three key contributors to inflationary pressures. This year, the economy faces the same price pressures, as well as surges in energy and food prices – all of which are contributing to rising inflation.

As a point of comparison, last year’s airfare prices rose by 10% and 9% in April and May. This year, the gains were 19% and 13%, respectively. And, given the persistence of supply chain disruptions in the automobile and other industries, elevated prices for both new and used autos are likely to persist through the end of the year.

On the more optimistic side, airfare prices should ease at the end of the summer travel season, and energy price growth should at least slow in coming months, absent another global shock to commodity markets.

Time is running out for inflation to show progress

Even with some easing of energy and airfare prices, we are still cautionary about the overall inflation picture.  Policymakers are using these broad pressures as the rationale the fastest pace of interest rate hikes since the 1990s.

Furthermore, policymakers have expressed a clear intention to increase the federal funds rate by 50bps at both the June and July meetings at least two more 50bps hikes in June and July. The Fed’s explicit communication around the path of policy at the next two meetings will pull forward some of the impact to today. This front-loading of monetary policy is one reason we expect inflation to ease at least somewhat over the summer.

Clearly, all the factors in the May report suggest that the Fed may need to do more in 2022 to tame inflationary pressures. As reflected in our recent chart book, the probability of a recession in 2022 remains low, but the risks are rising for next year. Our analysis shows that the economy can likely handle a neutral monetary policy stance, which we estimate to be a fed funds rate of around 2.25 – 2.5% If rates exceed that range, the risk of a 2023 recession rise significantly.

Although there are still a couple of months before the Fed will have to decide whether to move rates above neutral, time is running out given the pressures exhibited in the May CPI release. The unexpectedly strong release puts pressure on the data for June and July and suggests that both releases will need to show a meaningful downshift in inflationary pressures to avoid the Fed pushing the federal funds rate above neutral.

Key Takeaways:

• Inflationary pressures continue to strengthen despite interest rates that are expected to rise at the fastest pace since the mid-1990s.
• Still in play are many of the same forces that drove inflation last summer, such as elevated prices for new and used cars and pandemic-affected services. Considering that energy and food price continue to rise at a fast pace, there is an increased risk that inflation won’t ease in the next couple of months.
• There is still time, but the likelihood that the Fed will move rates above neutral, or 2.5%, is increasing. That raises recession risks next year.