CPI Reading Was Good

Yesterday we got the latest U.S. inflation report. And for the first time in a while, the numbers came in better than almost everyone expected. Wall Street breathed a sigh of relief, stocks rallied, bond yields fell, and investors were smiling.

Everyone... except one person. The new Federal Reserve Chair, Kevin Warsh. On the very same day, speaking before Congress, he kept his finger firmly on the trigger when it came to interest rates.

So how is it possible that such a strong inflation report still isn't enough?

WHAT THE NUMBERS SHOWED

Let's start with the data. The Consumer Price Index (CPI) fell by 0.4% during the month. And here's the remarkable part. It was the largest monthly decline since April 2020, back in the early days of the pandemic.

On an annual basis, inflation came in at 3.5%, while economists had expected 3.8%. In May it stood at 4.2%, so this was a meaningful drop, and an even bigger improvement than markets had anticipated.

"So what pulled inflation lower?" you might ask.

Energy.

The energy index plunged 5.7% over the month, again marking the biggest monthly decline since April 2020. Gasoline and heating oil both fell by more than 9%.

But here's the most important figure. Core CPI, which excludes food and energy, remained flat on a monthly basis. On an annual basis, it dropped to 2.6% from 2.9% in May, well below the 2.9% economists had expected.

In other words, it wasn't just cheaper gasoline doing the work. Apparel prices fell 0.6%, used vehicle prices declined 0.2%, shelter rose just 0.1%, and transportation services even slipped 0.3%.

WHAT IT ALL MEANS

The numbers look encouraging. But what do they actually tell us?

Put simply, Core CPI is the inflation measure the Federal Reserve pays the closest attention to. Food and energy prices tend to swing sharply from month to month. Core inflation, on the other hand, provides a much clearer picture of the underlying trend.

And this time, that trend looked encouraging.

There is, however, one major catch.

A large part of the improvement came from lower gasoline prices. And gasoline became cheaper because oil prices dropped roughly 25% during June, as tensions in the Middle East appeared to ease.

The problem?

That calm didn't last.

President Trump recently announced that the ceasefire with Iran was over, and oil prices have already started climbing again.

Do you see the pattern?

If oil prices surge once more, much of this inflation relief could disappear. That's why one word kept appearing across analysts' reports:

Temporary.

Goldman Sachs economist Kay Haigh put it plainly. The ongoing risk surrounding the Strait of Hormuz keeps the possibility of another rate hike very much alive. The path toward keeping rates unchanged still exists, but it has become much narrower.

WARSH'S MESSAGE

Now let's turn to the man holding the keys: Kevin Warsh.

On the same day the inflation report was released, the new Fed Chair testified before Congress. His message was unmistakably hawkish.

"The number one goal of the Federal Reserve is to get monetary policy right," he said. "That is our North Star."

He also added that the inflation surge of the past five years would become a thing of the past.

Warsh has repeatedly argued that inflation is "a choice." And this time he delivered essentially the same message in different words:

"We have zero tolerance for persistently elevated inflation."

Zero tolerance.

But perhaps the most interesting part of his testimony focused on artificial intelligence.

He pointed to AI investment, data centers, and technology infrastructure as the most remarkable feature of today's economy. In his view, the AI investment boom could eventually reduce inflation and even create deflationary pressures over time.

Many economists disagree with that assessment.

Warsh does not.

THE FED'S NEXT MOVE

So where does all of this leave us?

The federal funds rate currently stands at 3.50% to 3.75%.

Following yesterday's inflation report, markets quickly adjusted their expectations.

For the July meeting, the probability of another rate hike fell to 17%, down from 42% just one day earlier. In other words, investors now believe July will most likely pass without any change.

September, however, is a different story.

Markets still assign a 59% probability to another rate hike. That's lower than the 75% probability seen before the inflation report, but it still represents better than even odds.

And that's the dilemma.

On one side, the inflation data says, "Things are moving in the right direction."

On the other, the Fed's new chair remains firmly hawkish, while oil prices are climbing once again.