Next Fed rate hike size may be based on soaring 'core' costs, not energy prices

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It’s all about the core.

Core prices, which exclude volatile food and energy items, increased 0.3% in July following a 0.7% rise the prior month, according to the Labor Department's Consumer Price Index.

That held the annual increase at 5.9% after three straight monthly declines.

Consumer prices increased 8.5% from a year ago, down from a 9.1% annual rise – a 40-year high – in June. Gasoline prices fell but food and rent continued to march higher.

Core inflation includes all items consumers pay for like rent, transportation, medical services, cars, recreation, clothing, and education. And that core is expected to remain red hot, which could prompt the Federal Reserve to continue with aggressive rate hikes, economists say.

Economists, and the Federal Reserve, prefer looking at the core inflation rate because energy and food price spikes can distort general trends since they can be affected by short-term shocks like bad weather ravaging a year’s crops.

“While the headline number may look a lot better, the true gauge of whether inflation has peaked is what happens with core prices,” Greg McBride, Bankrate.com’s chief financial analyst, said.

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What's causing core inflation to move higher?

While overall CPI will benefit from the months-long decline in oil and gas prices as well as weaker prices for commodities like metals and wheat, the core will be bolstered by several things, especially rent. Rent inflation is the largest component of CPI, making up a third of the weighted index.

“We expect official CPI rent inflation to continue to run very hot,” Goldman Sachs chief economist Jan Hatzius said last week. He predicted rent inflation will increase in each of the next several months and peak at around 7% year-over-year before slowing. Annual shelter inflation was 5.6% in June.

Economists will also scrutinize other core services like medical services, which has about a 7% weight in CPI. Medical services – including professional medical services from dentists, optometrists, and other doctors, hospital services, nursing home services, adult day care, and health insurance – rose in June to a 4.5% annual rate, a nearly two-year high.

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Jumps in areas like medical services and rent are concerning because they can show just how widespread inflation is becoming, economists said. They are in categories that typically don’t see regular price surges so when their prices rise, economists consider this "sticky" or persistent inflation.

"Importantly, the sticky-price measure seems to contain a component of inflation expectations, and that component may be useful when trying to discern where inflation is heading," according to an Atlanta Fed explanation of sticky prices.

Don’t forget wage inflation

Friday’s blowout jobs report didn’t just show that the economy added more than half a million jobs last month. It also showed average hourly earnings rising a strong 0.5% month over month or 5.2% from a year ago. Economists had forecast a 0.3% gain month over month.

“The inflation worries motivating the Fed will only be heightened by this jobs report,” Michael Feroli, chief U.S. economist at JP Morgan, said.

Economists worry about persistently strong wage growth fueling what’s called a “wage-price spiral” in which higher wages force businesses to increase prices. That in turn causes more wage increases, and the loop continues.

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What if inflation stays hot?

After last week’s strong jobs report, many economists penciled in a third straight 75-basis-point increase in the Fed’s short-term benchmark fed funds rate at the central bank’s next meeting in September. Strong inflation figures this week would likely reinforce that view.

The Fed raises rates to make borrowing more expensive, which dampens demand for money and spending. Inflation often falls in a slower economy. Though the Fed doesn’t control all rates in the economy, consumer rates usually follow the trend in a ripple effect.

“Given the powerful inflation tailwinds indicated by the still overheated job market and sturdy wage gains, it is hard to fathom policymakers taking a more lenient stance in the inflation fight,” Bob Schwartz, senior economist at Oxford Economics, said.

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What if inflation eases?

Even if consumer inflation slows, rates are still going up but how much may be debated, economists say. Some still believe a half-point, instead of a three-quarter point, hike is likely, especially if inflation shows signs of softening in July and August.

“Inflation that stops rising is one thing,” Sal Guatieri, BMO Capital senior economist, said. “How quickly it retreats from four-decade highs is another.”

Rising wages due to a tight labor and rental markets are signs of persistent inflation, and faster increases in services prices are negating slower goods prices, he said.

“Stubborn inflation continues to pose the single biggest threat to the economy,” he said. “Inflation may not fall according to plan,” which would mean much higher rates.

Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at mjlee@usatoday.com and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday morning.

Paul Davidson

This article originally appeared on USA TODAY: Has inflation peaked? 'Core' prices better indicator than food, energy