US Daily Economic Notes:Core CPI inflation should firm, when will core PCE follow?

Commentary for Friday: Higher energy costs should push the headlineconsumer price index (CPI) up 0.3% in June. If the oil futures market is correct,year-over-year CPI energy inflation will be positive around Q1 of next year,thereby pushing the headline CPI up to a 2% year-over-year growth rate. On ayear-to-date (YTD) basis, the core CPI is already running well above 2% andthis trend should continue into June, which is expected to show a gain of0.2%. This would mark the fifth month out of the last six that the series hasincreased 0.2% or more, and should nudge the YTD annualized run rate up to2.4% and raise the year-over-year growth rate up a tenth to 1.8%. Moreover, ifthe recent trend persists, the year-over-year growth rate of the core CPI willsoon increase because for the next three months (July through September),the year-over-year comparison will be up against 0.1% readings. We believethe recent acceleration in the core CPI will continue for two reasons: One,shelter costs account for roughly 40% of the core CPI, and with the residentialvacancy rate near a 22-year low, the former are likely to expand faster thantheir current 2.9% year-over-year rate. Two, medical care costs in the CPI,while volatile, have been trending higher. This is shown in the chart below.Medical care prices have risen roughly 3% YTD through May. Interestingly, therecent trend in medical care prices within the core PCE deflator, which is theFed’s preferred measure of inflation, has been much less robust.

    As the chart below indicates, medical care inflation in the CPI has beendiverging from that in the PCE since Q4 2014 and the spread between the twoseries is currently near the high end of its historical range—PCE medical care isup only 0.6% YTD. The discrepancy is the result of differing methodologies.The CPI measures prices that the medical profession charges to consumers,while the PCE measures the revenues derived from the provision of medicalcare. The reason we are particularly interested in medical care prices is thatthey have the largest weight in the core PCE deflator (nearly 20%). Therefore,for the core PCE to firm to 2%, as the Fed so desires, medical care prices willhave to accelerate appreciably. The weakness in the latter is one reason whythe YTD rise in the core PCE has been only around 1.4%. Given the current5.3% unemployment rate and tentative signs that wage pressures may bebuilding, albeit off a low base, we believe it is more likely that medical careprices in the PCE will eventually rise to meet their growth rate in the CPI.