May CPI Report: Good News on Inflation, but Hold the Champagne

After unexpectedly hot inflation readings in the first quarter, May’s Consumer Price Index report brought good news.

The Bureau of Labor Statistics reported the overall CPI was unchanged for the month, below the 0.1% increase analysts expected. Core CPI (the measure of inflation that excludes volatile energy and food prices) rose by 0.2% on a monthly basis, also below the 0.3% consensus estimate.

Despite a strong positive reaction in the stock and bond markets, the outlook for inflation remains uncertain. “While we’re wary of overreacting to one month’s data, today’s inflation news was as good as we could possibly hope,” says Preston Caldwell, chief US economist at Morningstar.

Still, following a softer-than-expected April reading on the widely followed inflation index, the May report is seen as firming up the odds that the Federal Reserve will be able to cut interest rates in September. Before Wednesday’s report, doubts had been creeping into the markets around whether the central bank will have room to cut the federal-funds funds rate twice this year from its current target range of 5.25%-5.50%.

May CPI Report Key Stats

• CPI rose stayed flat for the month after rising by 0.3% in April.
• Core CPI climbed 0.2% after increasing by 0.3% in April.
• CPI climbed 3.3% year over year after increasing by 3.4% the prior month.
• Core CPI climbed 3.4% from year-ago levels after growing 3.6% in April.

Services Follow Goods Down

Core CPI saw its lowest increase since August 2021, Caldwell notes. “The low result was driven by core goods, but especially by core services excluding shelter,” he says. “In the latter category, inflation was low across the board for one of the few times in the past three years.”

Energy prices saw a significant shift, falling 2% in May, compared with a 1.1% rise in April. The change was more acute in gasoline prices, which fell by 3.6% compared with a 2.8% rise the previous month. Caldwell adds, “We should see a further drop in energy prices in June as well.”

Airline fares also experienced an unusually large drop. “The 3.6% drop in airline fares provided a particularly large downward impulse, reducing overall core CPI month over month by 3 basis points. So it’s highly unlikely that the next couple of months look quite as good for core inflation as May did,” says Caldwell.

Shelter Costs Remain High

While services inflation was low in several categories, housing costs remain high, but Caldwell expects even that may improve. He added the core CPI number is “particularly impressive, given that shelter inflation remains high, 0.4% month over month. An eventual fall in shelter inflation, which still looks highly likely, will provide further downward momentum for inflation.”

Positive News for Rate Cut Odds

The Federal Reserve favors the core Personal Consumption Expenditure Price Index for inflation, not the CPI. Caldwell expects “the core PCE is likely to come in around 5-10 basis points lower than Core CPI. Thus, the three-month change in core PCE should fall to around 2.7% annualized, and core PCE ex-housing at 2.2% annualized.” Looking at the three-month average, Caldwell says this brings the United States back to the “more benign inflation environment that had prevailed in the second half of 2023.”

This is good news for investors hoping for interest rate cuts from the Fed, according to Caldwell, “In the Fed’s March FOMC projections, they had called for cutting rates three times in 2024 if core PCE merely dropped to 2.6% year-over-year by Q4 2024. But we’re ahead of schedule, with core PCE likely to drop to 2.5% year over year for May. Logically, then, today’s news would seem to open the door to a July rate cut, although we still think that’s very unlikely, given the recent hawkish rhetoric from the Fed. But rate cuts starting by September should now be cemented as overwhelmingly likely.”

The market reacted strongly to the news, with yields on the 10-year Treasury down by 0.12%. Caldwell says, “The dramatic drop in bond yields looks like a bit of an overreaction to just one month’s data.” He thinks it helps to counteract the “overreaction to the uptick in inflation seen in Q1.”

Currently, the markets give a 70% chance of at least one rate cut by September, according to the CME FedWatch Tool, with a similar chance of two or more by December.