Today’s inflation update for May was ripe with conflicting signals. There’s enough here for inflation hawks as well as doves to keep the debate bubbling until the next round of numbers. Headline inflation slowed last month to a 0.2% rise on a seasonally adjusted basis, down from 0.4% in April. But core inflation, which excludes food and energy, accelerated, rising 0.3% in May—the fastest monthly pace in nearly three years. That’s still well within the Fed’s 1%-to-2% target range, but the fact that core’s rate delivered a rare increase above headline’s pace raises warning flags by some accounts.

“The indexes for apparel, shelter, new vehicles, and recreation all contributed to the acceleration [in core inflation], rising more in May than in April,” the Labor Department explains in a press release. “These increases more than offset declines in the indexes for airline fare, tobacco, and personal care.”
As for inflation’s annual pace, both headline and core CPI measures are rising, and at higher rates. As the chart below shows, headline inflation rose by 3.4% last month vs. a year ago, the fastest since late-2008. Core inflation’s year-over-year rate moved up in May as well, reaching a 1.5% increase vs, the same period in 2010.

Does this mean we have an inflation problem? Perhaps, or so the numbers suggest to some analysts. But there’s still room for debate. Let’s start with headline inflation. A key reason why broadly defined CPI’s pace dropped last month was due to the tumble in energy prices in May. True, oil and gas prices are still elevated and it’s not clear they’re headed materially lower any time soon. But without a sustained rise in energy prices from here on out, a key driver of headline inflation’s rise over the past year may be neutralized for the near term.
The rough patch in the economy certainly offers support for thinking energy prices may tread water in the months ahead. Today’s update on industrial production only strengthens the view that economic growth is struggling. The Federal Reserve reports that industrial production advanced a thin 0.1% last month, which translates into a 3.4% rise over the past 12 months—the slowest rate in more than a year.
It’s still tough to make the case that a new recession is brewing, but it’s equally difficult to see inflation roaring higher given the current macro malaise. Some will point to the acceleration in core inflation as a warning sign of new pricing pressures, although that’s premature. True, a 12-month rise of 1.5% in core CPI is more than double the annual pace as of last December, but that’s a good thing. Recall that core inflation was falling rather consistently for much of last year. The Fed’s QE2 monetary stimulus was designed to halt that trend. Mission accomplished. Meantime, core inflation at 1.5% is hardly extreme. If it keeps rising, that’s a problem, of course, but given the sluggish state of the economy, that risk looks minimal for the moment.
Still, there’s an opposing view, as articulated today by Barclays Capital senior economist Peter Newland. “All in all, today’s report provides further evidence of building price pressures across a broad range of goods and services, consistent with our view that the degree of economic slack is not that large,” he advises via The Wall Street Journal.
But Martin Schwerdtfeger, an economist at TD Economics, writes today that “a slowly declining unemployment rate will keep a lid on real wages. This will restrain unit labor costs, defusing one of the possible catalysts for higher inflation.” As a result, he forecasts that core inflation will average 1.5%, this year, or roughly holding steady at the current pace. Next year, he expects core CPI will rise to 2.1%.
Unless you’re expecting a sudden and powerful surge in the economy, Schwerdtfeger’s outlook sounds reasonable. Even so, today’s numbers will keep the market wondering: What happens next?
“The core reading of 0.3 percent is surprising and somewhat disturbing,” admits Josh Feinman, chief global economist at DB Advisors. “I remain pretty sanguine about inflation, but this month certainly doesn’t help.”