Fed Still Cornered as CPI Cools but M2 Growth Heats Back Up

Well, this was an odd one to sort out.

Going into the CPI announcement this morning, the economist consensus was for +0.17% (seasonally adjusted) on headline CPI m/m and +0.28% on core. Market changes this month have been very contained, partly because of the usual summer doldrums kicking in and partly (most likely) because of the degree of uncertainty surrounding all of the chaotic policy changes that have taken place in 2025. The effects of these changes (and more to come!) are still making their way through the system.

This is a calm surface over a roiling ocean. Economists continue to debate (and their analysis, to me, seems in many cases to be colored by the political lens they are looking through) about the impact that the current tariff structure will have, about the effect of future tariff changes – and what those will be, about the impact of the Most-Favored-Nation policy on pharmaceutical pricing and availability, about the effect the deportation of illegals (and self-deportations) will have on housing (rent inflation softer, but how much?) and labor supply (wages upward, but how much?) and Lodging Away from Home.

Actually, I’m overstating that a little bit. Most classically-trained economists mostly agree about how horrible this will all be, because tariffs bad. My own estimates have tariffs pushing inflation a little higher in the near-term, but not terribly. I also think that mass deportations would be very disinflationary because of the effect on rents but it is looking less and less like ‘mass deportations’ means tens or hundreds of thousands, not millions, and that effect likely won’t be huge.

Meanwhile, the Fed is keeping rates slightly above neutral but money supply growth has re-accelerated to a level that’s not likely to be consistent with inflation at 2%. Underlying trend median inflation is running about 3.5% or so, and is unlikely to fall a lot further given the current configuration of fiscal and monetary policy.

Let’s get into the data, then. The actual CPI was +0.08% (SA) on headline and +0.13% on core. That’s a significant miss, especially on core.

Core inflation has recently been missing low on a fairly regular basis, although most of the misses have been small. Median inflation in most cases hasn’t been confirming those misses, because they’ve generally been one-offs that don’t really wiggle median too much. It’s still a positive sign if the ‘tails’ are to the downside so that core CPI is below median CPI, but Median tells us not to get too excited. This month, though, Median also showed an effect. My estimate is that Median CPI will be the lowest since last July, at +0.25% m/m. It’s still difficult to see a major disinflationary trend here.

There’s more uncertainty than usual around my Median guess, but let’s take it as a given for now.

You don’t have to look too far to see one of the major culprits for the miss this month. Primary Rents were up +0.21% m/m, which is a lot slower than they had been running at.

Owners’ Equivalent Rent was also soft, and between those two surprises it’s probably roughly 5bps of the Core CPI miss. Let’s be clear – rents are not collapsing and indeed, we’ve just converged with our model.

Let’s be clear: if you are in the camp that we’re going to get back to 2%, you need this to not be an aberration. You need shelter inflation to continue to decelerate. But as you can see from the chart of month/month primary rents above, sharp movements in rents tend to be reversed in subsequent months. This looks a lot to me like last July’s surprise, which was reversed in August. We will see. But ex-shelter, year/year Core CPI rose, to 1.87% from 1.78%.

What is interesting to me as I write this, looking at some of the other commentary, is that folks don’t seem to be focusing on this. Of course it’s all tariffs, all the time, and everyone is scratching their heads over why we are seeing price declines in some of the categories where you’d expect the tariffs to help. Key example (and significant example) is autos, where the CPI for Used Cars and Trucks was -0.54% m/m after a similar decline last month, and New Cars were down -0.29% m/m. If there is one place that economists were certain we would see tariff-induced inflation, it was in autos. Not so much, at least yet. This might be because the lags are longer than we expect in a just-in-time manufacturing world, or it might be because demand elasticity is bigger than people thought.

But even with autos, Core Goods inflation accelerated to +0.3% y/y from +0.1% last month.

Remember, above I said that core goods ex-shelter had accelerated. I don’t want to fall into the trap of taking out all of the things that go down, to make the insightful conclusion that everything else went up – but that acceleration in core goods included the weighty autos contribution to the downside so you can tell that there are indeed upward pressures. Just not in the big things.

One place we saw increases was in Tenants’ and Household Insurance, which rose 0.84% last month, and in Motor Vehicle Insurance, which rose 0.68%. That helped keep core services inflation at +3.6% y/y, even with the slowdown in housing. On the other hand, Airfares suffered a third straight significant decline, -2.74% m/m. And while we are surprised to see auto prices decline, given the tariffs, we are also surprised to see Medicinal Drugs prices increase, given Trump’s new “Most Favored Nation” policy. Pharma prices were +0.54% m/m (although the y/y increase slackened some and is only +0.35% y/y). Core Services less Rent of Shelter (aka “Supercore”) is down to 3.11% y/y, and that’s good news even if it’s still quite a bit higher than it was pre-COVID. The trend is your friend, and this is a good trend for now.

As with the market itself, then, we’re seeing a lot of movement in both directions; it’s just all canceling out into a relatively tame increase in the overall CPI basket. That’s not likely to be the ultimate outcome. The last four year/year increases in Median CPI (assuming I’m vaguely right about the m/m, and we’ll know that in an hour or two) have been 3.53%, 3.48%, 3.46%, and 3.44%. That does not give the impression of a series that is in a hurry to get down to 2.25%-2.5%, which would be roughly consistent with sustainable core CPI around 2%. Again, you need to get shelter prices to really decelerate significantly further.

Now, even if that does happen, it isn’t going to keep y/y measures on a steady deceleration track for the next year. While we haven’t seen a major impact from tariffs yet, and my view is that it won’t be a huge impact in any case except for particular items, I am pretty sure we will see something and median and core inflation will see acceleration over the balance of this year and into next year. Thereafter, it depends on what happens with policy in the interim. On that score, while the current numbers still give the Fed no good reason to ease it also should pretty much remove any notion that monetary policy is about to get tighter. M2 growth is back to 4.4% y/y, and 6.4% annualized over the last quarter. That’s back to what was normal when we were experiencing the tailwinds of globalization and positive demographics. It is too fast now that those are headwinds.

But as I said, that’s the story for later this year and it could change. In the meantime, we keep waiting for the tariff effect. If three months from now we still haven’t seen an effect, then things will get very interesting.

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