Will the inflation rate keep falling?

Inflation is coming down. The Bureau of Labor Statistics, which measures the Consumer Price Index, reported the 12-month inflation rate for May at 4.0 percent, down a whole point from the 5.0 percent rate in April. Inflation had peaked in June 2022 at 8.9 percent, which was the highest inflation rate in 40 years.

Lower inflation is good news. The Federal Reserve has been raising interest rates to slow the economy so that businesses will have fewer reasons to raise prices. We're hoping for a "soft landing," which means solving the inflation problem without needing a recession. Economic growth has slowed, but the unemployment rate was 3.7 percent in May. That's near a 50-year low. There's no sign of a recession yet.

Wouldn't you know, there's some not-so-good news too. The "core" inflation rate was 5.3 percent for the 12 months ending in May, hardly down at all from 5.5 percent in January. That rate peaked at 6.6 percent last September. Core inflation is falling very slowly.

The core inflation rate removes food and energy prices from the all-items rate. Those prices are especially variable. They can rise rapidly or rise slowly and sometimes they fall – which most other prices hardly ever do. The core rate tries to see inflation's underlying trend, without the noise from the most volatile prices.

Stubborn core inflation means that the all-items inflation rate has fallen so much mostly because energy prices have come down. A year ago the average price of gasoline nationwide was over $5 a gallon. Now it's more like $3.70. That big 12-month price drop is included in the all-items inflation rate. Take out gasoline, which the core rate does, and inflation is down only a little.

What's holding the core rate up? Not goods prices. The prices of cars and computers, clothes and medicine are up only 2 percent over the past 12 months. Goods price inflation peaked at 12.4 percent in February 2022, so it's way down.

It's service price inflation that has not come down, and the biggest component of services by far is shelter. People spend a large part of their budgets on rent or mortgage payments, so the prices of shelter loom large in the CPI. The 12-month inflation rate for shelter was 8 percent in May, down hardly at all from its peak of 8.2 percent in March. More than anything else, rents are keeping the inflation rate from falling.

It turns out that shelter inflation lags goods inflation by about a year. Inflation in goods prices falls, and a year later shelter inflation starts to drop. One reason is that people sign leases that fix their rents for a year or more. Many leases that are expiring now set rents back when inflation was high. Those high rents are still being paid, so shelter inflation hasn't started to fall yet.

The drop in goods inflation really got going from February to June last year. That means shelter inflation should start declining 12 months later, which is, well, now. A decline is a bit overdue. At least one private sector index that measures current rents shows falling rent inflation in 2023. (Search the web for "Apartment List Rent Report.")

There will be another drop in the 12-month all-items inflation rate for June, when the Bureau of Labor Statistics reports it on July 12. We know this because the 12-month rate is pretty much the sum of 12 individual one-month rates. The monthly number for last June will drop out, and the figure for this June will be added. June 2022 was the peak of energy price inflation. Since gas prices have not spiked up to $5 so far this month, this June's inflation rate will be lower. So, take out last June's big inflation number, add in this June's smaller number, and we should see a 12-month inflation rate in the low-3 percent range.

June 2022 is the last big monthly inflation number that will drop out. For the July CPI report coming in August, progress on overall inflation will happen only if shelter inflation starts to fall. If that happens, perhaps the Federal Reserve can call a halt to interest rate hikes. Perhaps we'll get our soft landing.