Another benign US CPI report, but risks persist

Inflation was fairly contained in July and in line with expectations, with headline CPI easing to 3.4% year-over-year. Core inflation also slowed further, to 2.5%, suggesting a gradual moderation in price pressures. While today’s benign inflation report marks an encouraging development for markets and policymakers in the near-term, the ongoing volatility in oil prices and the risk of prolonged disruptions in the Middle East suggest upside inflation risks cannot be entirely dismissed. 

Report details

Headline inflation rose just 0.1% in July, in line with expectations and marking a modest rebound after June’s decline, while the annual rate eased from 3.5% to 3.4%. There continues to be little evidence so far of second-round inflation effects due to the Middle East conflict, reducing the likelihood of imminent policy tightening. That said, with the Strait of Hormuz remaining shut, the risk of renewed inflation pressures should not be ruled out.

Energy remained a drag on prices, reflecting some moderation in oil dynamics from the $110+ per barrel prices seen in the spring. Nevertheless, crude oil prices remain elevated relative to pre-conflict levels, and the situation in the Middle East remains fluid. Therefore, the recent relief in energy prices should be received with caution given how quickly supply disruptions in the Middle East can feed through to oil prices, energy costs, and ultimately headline inflation.

Food inflation remained contained in July. The modest increase was driven primarily by food away from home. Grocery prices declined slightly, with four of the six major categories posting monthly declines. The decline in food at home inflation is an encouraging shift following June’s broad gains. Looking ahead, any prolonged disruption to trade flows through the Strait of Hormuz could place upward pressure on fertilizer costs, creating potential upside risk for food prices.

Core inflation, which excludes food and energy, rose 0.2% for the month, in line with expectations and up from an unchanged reading in June. Importantly, the modest monthly uptick was in line with what is broadly perceived as progress toward price stability. The annual rate slowed from 2.6% to 2.5%, reinforcing the narrative of moderating prices. Shelter inflation remained subdued, rising just 0.1% for the month, and remains an important offset to inflation pressures elsewhere in the economy. By contrast, other core services categories, including medical care, airline fares, education, and communication services, contributed to higher prices. Except for airline fares, however, annual increases across these categories remain contained.

Core goods prices posted a small increase after two consecutive monthly declines. While the impact of tariffs has gradually faded, upward price pressures are showing up in tech-related goods, likely due to the AI capex boom driving up demand for semiconductors. Another notable development was the rise in vehicles and parts inflation following an extended period in which deflation provided an important offset to broader price pressures. While the annual rate still looks benign, it’s worth monitoring given that vehicles and parts are not immune to semiconductor developments.

The Fed’s preferred supercore inflation measure rose 0.2%, bringing the annual rate down to 2.8%, from 3.2%. Given that this measure is largely influenced by wages, continued softness in wage growth is helping offset broader inflationary pressures.

Policy outlook

Two consecutive benign inflation reports, alongside July’s decline in payrolls, should help ease concerns of a September rate hike. Still, as inflation persists above the Fed’s target, the possibility of a hike cannot be entirely dismissed, particularly if the August inflation report shows renewed acceleration in price pressures.

Encouragingly, tariff-related price pressures have eased, while softer wage growth and subdued shelter inflation are helping offset broader inflationary pressures. However, with the Strait of Hormuz still shut, further disruptions to trade flows and their immediate impact on energy prices and headline inflation, as well as potential second-round effects, will likely remain top of mind. We continue to expect no change in rates this year, but cannot dismiss the elevated risks of a hike later in the year if energy disruptions are sustained. Meanwhile, the possibility of AI-related capex contributing to inflationary pressures also warrants close monitoring.