What does the July CPI report tells us about inflation trends?

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Phoebe White: Welcome to Research Recap on J.P. Morgan's Making Sense. I'm Phoebe White, US Rate Strategist and Head of US Inflation Market Strategy. And today I am here with our Global Chief Economist, Bruce Kasman, to discuss takeaways from the July CPI report, the path ahead for inflation, and what this means for monetary policy. Bruce, thanks so much for joining.

Bruce Kasman: Hey, Phoebe. Good to be here.

Phoebe White: So let's just start high level. What were your main takeaways from this report?

Bruce Kasman: So I think I'd probably make three points here. The first point is the, perhaps the most relevant one from the conversation, is I think we are seeing tariffs starting to be passed through perhaps not as immediately as might have been, uh, anticipated a few months ago. But there's clearly pressure upward on prices in the US as a result of higher tariffs. I think the second point I'd make is that when you kind of try your best to cut through the, the noisy swings we're having in a number of components of prices, I think the broad sweep of data, both in the price and the wage space, still suggests that underlying inflation in the US is probably around 3%. And then the third point I would make is that while it's not a huge benefit, we are getting some support as we're going through the middle part of the year in terms of falling energy and some downward pressure on food. That's offsetting to some degree the tariff pass-through that's squeezing household purchasing power.

Phoebe White: Great. I think that's a, a good place to start. And maybe let's just start with that first point, about goods prices and the tariff pass-through. We saw a two-tenths increase in core goods last month. If you strip out autos, it was also just a two-tenths increase, which is a softer increase than we saw the prior month. But I think if you take a step back, uh, the last three months annualized that goods X autos component is running close to 4%. So there's clearly been that uptick in, in goods inflation. Uh, as you said, seems there there is some tariff pass-through going on.

Bruce Kasman: Mm-hmm.

Phoebe White: Let's take a step back though and and talk about where that effective tariff rate is now, how much substitution and redirection of trade we've been seeing, where that tariff rate is going, and what that means for goods prices from here.

Bruce Kasman: So just on the tariff rates themselves, our broad estimates, using a static basket of where we were in 2024 in spending, we've probably moved up to about 16% in June and July, which is where this report is measuring prices. We think we're continuing to move up with the August announcements and probably some sectoral tariff announcements to come to something close to 20%. If you think about where actual revenues generated were, the data we have is for June and we are probably sitting somewhere closer to 11%. So there is lags in terms of the payments of tariffs. There is substitution that's going on here. And I think probably the most important substitution is within Asia, which is between China, which has had tariffs of somewhere close to 40% and other economies up, which up until the August announcements have had tariff rates generally below 10%. And that that feeds into a, a goods component story as well, as the electronics particularly have been exempt from, uh, tariffs up till now. And I think our basic point is that these gaps are closing with the August announcements. We're likely to see observed tariff rates get up to something in the 15 to 17% range in the next three to six months. There'll still be a decent amount of incentive for evasion. But nonetheless the pressure, I think, on the economy from higher tariff rates is gonna build here. The pass-through to prices, as we described a minute ago, is building but still modest. And I think the real question here is not whether there's more pass-through, but whether that pass-through is gonna be concentrated or is gonna get spread out over six or nine months. I think that is important for how it affects consumer behavior and the economy more generally. But that's the real uncertainty, which, which in some basic sense, the data today continues to lean in the direction of a more gradual pass-through, even if that pass-through is significant.

Phoebe White: Right. That timing component is important. But maybe just on this point about pass-through, the pass-through is coming, I think a lot of people have been asking just how much of it will fall on the consumer though.

Bruce Kasman: Yeah.

Phoebe White: And with each of these reports we're trying to figure out, you know, how much can be absorbed in profit margins and also whether you're seeing any evidence of exporters bearing the brunt of the tariffs. Do you see any evidence that exporters could be offsetting some of the, the pass-through?

Bruce Kasman: Well, I think on the exporter side, I think there's been some evidence in certain specific items, like Japanese auto exports to the US, that you've had some uh, absorption. But I think if you look at the broad sweep of macro data, first of all, the fact that we have an observed tariff rate of 11% means that (laughs) there's an 11% rate that's actually being paid by somebody in the domestic economy because tariffs are being levied after the goods come into the US. If you look at import prices today, import prices ex-fuel are continuing to grow at a actually faster pace than they were a year ago. So there's not, in the aggregate, I think, a sense that there's a big absorption of these tariff rates by foreign exporters. What there is is I think a message that so far, either some combination of having built inventories and therefore having goods that aren't being tariffed, these substitution effects we talked about, uh, earlier, are limiting the impact but that the impact is starting to be felt. And again, you mentioned the numbers earlier, we're running close to 4% on the three-month run rate on goods prices, ex-autos. And I would note in a couple of key services sector, particularly, for example, today we saw some huge increase in the price of dental services and I think most of that is imported, uh, products that are being used to provide dental care in the US. So there is pressure there. As I said before, I think the issue is the timing more than whether we're gonna get it. We would estimate that when the dust settles, we get about two thirds of the tariff shock being passed through to consumer prices. And we feel still reasonably comfortable about that, notwithstanding the uncertainties around how long does the pass-through, uh, take.

Phoebe White: Let's talk about some of the other services components. I think there's been a lot of focus on rent inflation-

Bruce Kasman: Yeah.

Phoebe White:... that has gradually been coming down and that's also helped to offset some of the upward pressure coming from goods prices. supercore inflation was running very soft this spring and we did see some bounce back in July. How are you thinking about the underlying trend in service price inflation generally?

Bruce Kasman: Well, when I said to you before that I think underlying inflation is still running at 3% in the US, that's a story that has, embedded in it, some underlying increase in goods price pressures partly related to the tariffs but not exclusively, and has a, uh, a worldview that underlying service price inflation is still running materially above 3%. In that 3% on service price inflation as we saw today, um, there was a further moderation in rent of shelter, and I would kind of put as a point of reference about a 3% inflation rate on rent of shelter in terms of where we'll go forward from here. That's materially lower than we've been running over the last year or two. It is not far, it's pretty close to what the average pace had been before the pandemic. But we do think in a world in which labor markets are tight, in a world in which wage costs and unit labor costs are running above levels that have been consistent with their pre-pandemic trends that we're gonna continue to see elevated supercore. And I think what's useful, although not decisive in today's report, is that after a string of low side numbers, we had some rebound, which is something I think we were expecting in a world in which those low side numbers seem more noisy than actually signal.

Phoebe White: Right. And so as you said, I mean just to put the numbers on it, OER inflation is running 3.5% the last three months. Primary rent is down to 2.8%-

Bruce Kasman: Yeah.

Phoebe White: ... annualized the last three months. So it seems to me those rent inflation categories have already fallen a lot and probably don't have a- much further room to, to soften from here. Let's touch on wage inflation.

Bruce Kasman: Lemme just jump in here.

Phoebe White: Sure.

Bruce Kasman: And say, I think if we're looking at the next six to nine months, I would go with a four, three, three and a half rule, which is that core goods run four, rent of shelter run three, and supercore runs three and a half. And that's smoothing through some of what might be lumpiness around tariff increase. And as you can think about, given the weights of that, two things come across. One is the average is gonna be above 3%. And secondly, and importantly, we're gonna start to see core PCE firm relative to CPI as the weight in course PCE of supercore and goods is much higher than uh, rent of shelter, which is the reverse in the CPI.

Phoebe White: Right. And that will have implications for the Fed, which I do wanna touch on. But before we go there, maybe we can touch a bit more on wage inflation. You talked about what we were seeing in unit labor costs.

Bruce Kasman: Yeah.

Phoebe White: Um, you know, Powell has said multiple times that he doesn't think the labor market is exerting upward pressure on inflation right now.

Bruce Kasman: Yeah.

Phoebe White: Um, you know, depending on which in- wage inflation measure you're looking at, some of them are starting to sort of flatline here. Where do you think we're going with wage inflation?

Bruce Kasman: Well, I would say that wage inflation is maybe not putting upward pressure on wage inflat- on, on price inflation, but it's not putting downward pressure either. And I, if, if you take the view that I have, certainly that underlying inflation is at 3%, that means that where inflation is sitting right now is probably broadly consistent with a sideways move at a still elevated level. And in that, what I'm suggesting is if you read the wage numbers, after having moved down nicely, it looks like we're settling. If you look at Atlanta, if you look at the average hourly earnings numbers, if you look at the ECI numbers, they're not all quite the same. But I think the broad message from there is that wage inflation has perhaps started to move sideways at about a 4% annualized pace. If I look at where productivity trends are, and that's a, a bit of a crapshoot as you well know in terms of trying to tie that down, I would say we're sitting somewhere in the one to one and a half percent range, building in a much softer underlying pace of growth as part of that slowing in productivity relative to the last two or three year trend. What that suggests is unit labor costs are running probably somewhere like two and three quarters and three, and I think that is broadly consistent with about a 3% inflation rate. These, these numbers don't tie down very closely over short periods of times. I think they're just sort of guides to where consistency is. And my point would be the labor market right now is not sending a consistent message with inflation getting back to 2%.

Phoebe White: Right. And I, I just wanna ask about im- immigration here because I know that's coming up a lot.

Bruce Kasman: Yeah.

Phoebe White: But how does your view on what's happening with immigration dynamics tie into that wage inflation story? Do you think reduced immigration will put upward pressure on wages, or is it both a supply and demand story and therefore it doesn't have much impact?

Bruce Kasman: I think it's both a supply and demand story. And I think the complication here is that we do think growth is gonna be on the soft side here, but at the same time, the weakening in immigration flows is gonna have an offsetting effect in terms of keeping labor markets tight. And then you've got the tariff related stuff. So there's, there's three impulses I think that are working here. One is how much is, uh, demand actually weakening? If we kind of take, as a broad rule of thumb, growth at 1%, that's a subpar growth rate certainly and that will have a weakening effect on pricing power. But how much will that be offset by what we just described, which is a wage number that stabilizes at an unsustainably high pace. And part of the reason, an important part of the reason why it's there is because the falloff in immigration flows is not pushing the U-rate higher. So a U-rate of 4142 is not consistent with getting diminishing pricing power, wage pressure, uh, through the system. And then the third issue is to what degree does the tariff pass-through generate persistence in terms of how the spike or the, at least the pass-through of inflation in the next six to nine months, has an impact on price and wage setting going forward. Those are things we're gonna take a while to figure out. My, my simple point, my strong point is I don't think you wanna bet on inflation coming back down to 2% on its own in that environment without weaker growth and what we're forecasting.

Phoebe White: So does that leave us with the Fed, and what does the Fed need to see to-

Bruce Kasman: (Laughs) The Fed eases of course.

Phoebe White: ... cut in, in September? (Laughs).

Bruce Kasman: (Laughs). And that may sound odd given what I just said because I'm not arguing the Fed is on track towards getting its inflation target. But I think right now when you're in a world in which you have, uh, concerns about growth triggered to the point that recession risks become elevated, you do not trade off the, um, the current standing of where labor market tightness and inflation is. So if we were just looking at U-rates and inflation performance right now, I don't think there'd be a strong case for the Fed to ease. However, I think in a world in which private payroll growth has slowed as much as it has, it is, in my mind, signaling a concern in terms of, um, the economy possibly faltering. Historically, that's what that kind of weakness would suggest. The economy doesn't look like it's faltering right now in terms of things like layoffs and things like financial conditions and things like CapEx. But I think the, the faltering signal, the stall speed signal is what I've been calling it, is significant enough that the Fed goes into risk management mode and it provides some easing. That easing will not be material if those risks are not realized, because of what we've just described in the last five or 10 minutes on underlying inflation and tightness of the labor market. But I do think it's enough to get you somewhere between 50 and 100 basis points on Fed easing over the next six to nine months if we're right, that the economy's soft labor demand will continue to be soft, and there is elevated risk that things could go wrong and the economy slip into recession.

Phoebe White: Right. And the market seems to be pretty well priced for that. We have about 23 basis points of easing priced for September. About 60 basis points or so, so priced through the end of the year. I wanna talk also about data quality questions and perhaps, more importantly, the event two weeks ago where President Trump fired the BLS commissioner. Do you think there is a risk of the data collection process becoming politicized?

Bruce Kasman: Yes, and I think that gets reinforced by last Friday's announcement of the new BLS Commission. I do think the administration has an objective to try and make sure that all of the arms of the federal government are working in terms of its objectives, and I don't think maintaining accuracy and objectivity of data is necessarily the highest priority. I do believe that it is not enough to change a director to undermine that, but I do also worry that over the next number of months, we could see turnover in terms of staff, changes in terms of procedures which could have that negative effect. So it's not happened yet, it may not happen, but I do feel, uh, the actions that have been taken with regard to the BLS, and certainly we recognize the primacy of CPI and payroll numbers in terms of our economic signaling, does mean that there's a legitimate concern here that we should be aware of.

Phoebe White: Certainly gonna be i- in focus for markets for, for a while. Before we wrap, we have talked a lot about the US. How is the inflation picture looking outside the US? Uh, are you still seeing a divergent kind of inflation outcome between the US and the rest of the world?

Bruce Kasman: So as you know, our view has been that there would be a substantial gap opening between US inflation performance and the rest of the world as we move through the second half of the year. And I think there's two things behind that. The first is, the obvious one is that US tariff rates, which are attacks on imports and do get passed through to the consumer, they're happening in the US and we're not seeing it happen anywhere else. So the tariff story we talked about earlier is a uniquely US affair. There's a little bit in Canada and maybe I'm missing one or two countries, but it's really not a global affair. The second thing is that the US is operating with a tight labor market, with having had very strong macro performance for some time. And the underlying inflation I think is sitting here stuck at a higher level in large measure because the economy has done, done well. That's not the way I would describe almost everywhere else in the world where there's slack, where there is, uh, relatively weak pricing power. And let's add to this story, the dollar's fall over the last six or nine months. So when I put all of those things together, I think what you're seeing in places like Western Europe, uh, and in some other parts of the world is the continued unwind of some of the, um, forces that have held service price inflation and wage inflation up. I think we can see the momentum clearly swinging in Euro area, UK, uh, the Scandies, and in some other parts of the world. And therefore, I think both the, uh, tariff effect and the difference in the slack labor market story is in indicative of a rotation in inflation that's going to move higher in the US but lower elsewhere across, uh, the globe. Japan is, of course, a notable exception and we do have the Bank of Japan tightening on the back of rising wage pressures and uh, uh, inflation that stays stuck above 2%, uh, their current target.

Phoebe White: So given that expectation of an inflation rotation, does that mean that other central banks will be easing more?

Bruce Kasman: I think actually generally not. Now there is a story here where I think some high-yielding EM economies, if we're not in a world in which the dollar's screaming higher, global financial risk appetite is being removed, countries like Russia, Turkey, Brazil, uh, India, others have room to ease and we think they'll take advantage of it. But if you leave aside those high-yielders, I think what's interesting is that we're not gonna see the Fed ease less than other central banks. And I think the reason for that is about risk management, and we already talked about the Fed being a risk manager that will respond to recession risk in a very sensitive way. I think the Bank of England is similar. And I think to the extent that we continue to see weakness, we might get a more pronounced response from them. But in other countries, I think there's a different type of risk management and particularly let's focus on, on Continental Europe where historically there's been an insensitivity to inflation undershoots. So even though there's slack in the Euro area, even though the, um, inflation picture as we think is gonna go down below 2% over the next six or nine months, and even though policy stances are being perceived as no lower than neutral, we don't think the ECB is gonna go into an accommodative sense to fight disinflation risk here. And I think that is the counterpoint to the Fed's risk management of heightened sensitivity. They have the heightened insensitivity to disinflation or inflation undershoots.

Phoebe White: Great. Well, let's leave it there for today. Bruce, thanks so much for joining. And thanks to our listeners for tuning in. For more research insights, visit jpmorgan.com/research.

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