Unexpected inflation slowdown could stall Fed later this year

Consumer prices edged down 0.1% last month following a small 0.2% increase in April, the U.S. Labor Department reported Wednesday. Prices had fallen 0.3% in March. In addition to a drop in energy costs last month, the price of clothing, airline fares and medical care also declined.

Core inflation, which excludes energy and food, rose a slight 0.1% in May.

“We take some reassurance from the fact that prices for core services have firmed somewhat,” says senior economist at TD Bank Leslie Preston, in an economics report. “And, while core goods prices continued to be weak in May, price pressures are building at the import and producer level. It is likely only a matter of time before these are passed on to consumers.”

The Federal Reserve boosted its key interest rate Wednesday. But some economists suggested that the unexpected slowdown in inflation in recent months may cause the Fed to slow the pace of further rate hikes.

“From out of nowhere we have now had three months of unusual weakness in underlying prices,” said Paul Ashworth, chief economist at Capital Economics.

He said the inflation slowdown was occurring at the same time that the unemployment rate has fallen to a 16-year low.

Speaking before the hike, Ashworth said in a research note,“It won’t stop the Fed from hiking interest rates later today, but it increases the downside risks to our forecast that there will be a further two rate hikes in the second half of this year.”

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Over the past 12 months, consumer prices are up 1.9% while core inflation has risen 1.7%. The Federal Reserve seeks to manage interest rates to promote moderate annual gains in inflation of 2%. The Fed’s preferred measure of inflation, tied to consumer spending, has been below 2% for five years and in recent months slipped back a bit.

Read: Fed will keep raising rates slowly. Here’s why

However, Fed officials have said they believe the recent slowdown in price gains reflect transitory factors, and they expect inflation will resume moving toward 2% as low unemployment helps to boost wages. Unemployment in May dipped to 4.3%.

Preston says that, given upstream price pressures and a tight labour market, “we expect inflation pressure to build through the remainder of the year. […] Still, the fact that these price pressures are proving slow to show up does add considerable risk to further Fed hikes later this year.”

Retail sales drop

Meanwhile, Americans cut spending at gasoline stations, department stores and electronics shops in May as retail sales registered their biggest drop in 16 months — a cautionary sign for the economy.

The Commerce Department said Wednesday that retail sales dropped 0.3%, the first decline since February and the sharpest since a 1% decrease in January 2016. Economists had expected sales to increase slightly in May after rising 0.4% in April.

Over the past year, retail sales have risen a solid 3.8%.

Economists have said they think consumer spending, which accounts for about 70% of U.S. economic activity, will pick up in the spring and summer. A slump in consumer spending early this year is a key reason why the economy expanded at only a lacklustre 1.2% annual pace from January through March.

The Trump administration has said it can accelerate economic growth to 3% a year by cutting taxes, loosening regulations and pouring money into roads, bridges and other infrastructure projects.

But President Donald Trump’s agenda has been held up by political turmoil and a lack of details from the administration. And economists are skeptical that Trump could overcome longer-term problems that weigh on economic growth, including an aging workforce and a slowdown in worker productivity.

Also read: CPI at 1.6% for second month amid higher energy prices, lower food costs