Inflation shows signs of easing, but that probably won't stop a 40-year high and a big Fed hike

First, the good news.

Several early warning signs of inflation – including commodity prices and inflation expectations – are easing, and economists say that should lead to softer price increases in a few months.

"There does seem to be a lot of things taking shape that (indicate) declining price increases will materialize," says Barclays economist Jonathan Millar.

The bad news: The encouraging data isn’t likely to show up in the June consumer price index (CPI), due out Wednesday, and the annual rise is likely to notch another 40-year high of 8.8%.

That ugly report will probably prompt the Federal Reserve to jack up its key interest rate by three-quarters of a percentage point for the second straight month, according to economists and fed fund futures.

Friday’s jobs report helped solidify the move because it showed strong employment gains of 372,000 and a big drop in the number of workers looking for jobs, a dynamic that tends to push up wages.

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Another big Fed hike would continue to sharply increase borrowing costs for consumers and businesses and disappoint stock investors reeling from a flurry of aggressive Fed moves intended to tame runaway prices.

Fed Chair Jerome Powell said in June that officials debated a three-quarter or half-point increase for this month. Though hefty, the latter option would serve as a balm for frazzled markets.

As the forces behind inflation show signs of gradually abating, Barclays revised down its year-end CPI forecast to 5.7% from 6.3%. Normally, the Fed is more attuned to such leading indicators of the economy’s future than reports of past performance, such as the June CPI.

But not now. Fed officials are determined to tamp down consumers’ inflation expectations, and that means making sweeping gestures that Americans can understand, Millar says. Such expectations are critical because if workers anticipate higher prices, they’ll demand similar-sized pay raises and companies will do the same, perpetuating a cycle of rising wages and prices.

“(The Fed is) saying, ‘We need to see clear and compelling evidence that inflation is coming down,’” Millar says. "They need to see it in hand.”

For similar reasons, Fed officials veered from their traditional practice of focusing on core inflation, which strips out volatile food and energy items, rather than the overall figure. That broader number features skyrocketing gasoline prices and substantially affects Americans’ inflation outlook.

Although average pump prices have fallen more than 30 cents to $4.68 a gallon over the past month, they jumped more than 10% in June. Food prices probably rose 1% and 10.3% annually, Barclays estimates, largely because of the effects of Russia’s attack on Ukraine.

Hotel rates, rents and car prices are expected to have recorded price increases last month, Barclays says.

There are signs that inflation should pull back, though it takes time for such changes to work their way into consumer prices:

Oil, wheat prices fall

Prices of oil, wheat, corn, copper and other commodities have tumbled on fears that a potential recession will douse consumer demand.

“Futures prices are falling despite physical markets still being tight, suggesting that demand destruction is taking hold, which will be key to getting inflation back on target,” Deutsche Bank says in a research note.

Easing stress on the supply chain

Several measures of stress in the supply chain – including shippers’ costs, delivery times and order backlogs – are falling, say Millar and Ian Shepherdson, chief economist of Pantheon Macroeconomics, citing reports by the Federal Reserve Bank of New York and Institute for Supply Management.

That’s probably because consumer demand is dropping and the improving pandemic allows more port, trucking and warehouse employees to return to work.

Inflation expectations dip

That’s according to the latest measure of consumers’ inflation expectations and a reading that looks at the price of bonds that protect against inflation. Both measures show consumers and investors expect inflation will drift close to the Fed’s 2% target in several years.

Smaller pay hikes

The Labor Department’s past two jobs reports showed annual average hourly wage increases declining from 5.5% in April to 5.1% in June. That survey can skew the average, which is affected when lots of workers in low-wage industries, such as restaurants, are hired.

Other reports that account for such effects, such as the Employment Cost Index and Atlanta Fed wage tracker, show average pay rising, though data out this week could reveal a shift.

Swollen inventories

Retailers ordered too many products late last year to battle the supply troubles. Their bloated inventories will probably translate into discounts for consumers, Millar says.