US: Long time since we have had a positive surprise on inflation - RBS

Research Team at RBS, notes that the latest data showed that the US CPI rose by more than expected in August, climbing by 0.2% overall and by 0.3% excluding food and energy (+0.252 unrounded).

Key Quotes 

“On a year/year basis, the core CPI edged back up to 2.3% after slipping from 2.3% to 2.2% in July. We do not think these data meaningfully raise the odds for a Fed hike in September, but they may ensure that the door is kept open for action later this year (e.g. shift in the FOMC language to indicate that the risks to the outlook are "nearly balanced").

Turning to the core rate, the upside surprise was in large part due to medical care, which jumped by 1.0%, the largest monthly increase since February 1984. Within medical care, prescription drug prices advanced by 1.3%, while hospital services jumped by 1.7%. Medical care costs have been accelerating, with gains of 0.3% (May), 0.4% (Jun), 0.5% (Jul), and 1.0% (Aug) in the last four months. On a year/year basis, medical care costs are now rising at the fastest pace since late 2007.

It has been a long time since we have had a positive surprise on inflation. One month doesn't make a trend, but with profits under pressure/unit labor costs rising, firms have to either pass increased costs along to consumers or else pull back in areas like capex and hiring. Perhaps companies are doing a bit of both. The end result is a stagflationary mix (slower growth/higher prices). We have long argued that this combination would be the theoretical consequence of the recent policy mix, namely very accommodative monetary policy against the backdrop of restrictive fiscal and regulatory policies.

Finally, given the higher-than-expected core CPI reading, we have revised up our core PCE forecast though we still expect that measure to post a smaller month-to-month change, rising by 0.2% (+0.185% unrounded). Nonetheless, this should be enough to lift the year/year rate from 1.6% to 1.7%, matching the February 2016 reading (which was the highest since September 2014).

The jump in medical care in the CPI was driven by prescription drugs, hospital services, and health insurance. While medical care commodities will feed through to the core PCE deflator, the hospital services components of the PCE deflator is sourced from the PPI and not the CPI. In the PPI, hospital services costs were relatively firm as well (+0.3%) though not as strong as in the CPI. Also, in the core PCE deflator, those costs get deducted from the NonProfit Institutions Serving Households (NPISHs) category, further limiting the impact of higher healthcare costs on the core PCE. As shown in the table below, the relatively firm core CPI result gives us a relatively elevated base upon which to build our core PCE forecast, and those categories sourced from the PPI will also make a positive contribution.

However, the NPISHs component and seasonal adjustment effect could provide a modest offset. On balance, we now look for a 0.2% core PCE gain in August (versus our earlier forecast for an increase of just 0.1%).”