US May CPI seen topping 4% for first time in 3 years

Wall Street expects a split-screen CPI tonight: headline inflation above 4% for the first time since 2023, while core inflation may run cooler than consensus.

The Bureau of Labor Statistics will release May CPI at 8:30 a.m. ET Wednesday, with headline inflation expected to breach 4% for the first time in three years as the Iran war-driven surge in gasoline prices distorts the inflation picture.

"This print has elevated tail risk — a hawkish surprise generates a larger market move than a dovish one," JPMorgan analysts wrote in a note Tuesday, assigning a 0.48 standard deviation upside bias to inflation swap pricing relative to economist forecasts.

Goldman Sachs, UBS, Deutsche Bank and Morgan Stanley all forecast headline CPI between 4.17% and 4.3%, up from 3.81% in April. The Cleveland Fed's nowcast sits at 4.18%. Yet core CPI — excluding food and energy — is expected to rise just 0.17% to 0.22% month over month, well below the 0.27% to 0.3% consensus, as moderating shelter costs and softer auto insurance weigh on the core reading.

The divergence creates a uniquely difficult trading environment. If the market focuses on the headline breach, rate-hike fears could push the S&P 500 down 2% to 3%, JPMorgan estimates. If core surprises to the downside, the index could rally 1.5% to 2%. The data arrives one week before Fed Chair Warsh's next policy decision, with futures pricing a 72% probability of higher rates by year-end.

Energy is the culprit behind the headline spike

Retail gasoline prices surged after the outbreak of the Iran war, pushing the energy component of CPI up an estimated 4% month over month in May. Deutsche Bank calculates that energy inflation year over year is approaching 24% — a dramatic swing from just 0.5% in February. Airline tickets are expected to rise 1.3% to 2% month over month as higher jet fuel costs pass through to consumers.

The good news: gasoline prices peaked May 20 and have since fallen about 40 cents a gallon. UBS estimates this will shave roughly 0.13 percentage point off June's headline CPI, pulling the year-over-year rate back toward 3.81%. That suggests May may represent the peak for headline inflation this cycle.

Core tells a different story — shelter and insurance cool

The core reading benefits from two forces that have historically kept US inflation elevated. Owners' equivalent rent and primary residence rent are both expected to rise just 0.22% to 0.23% month over month, a sharp deceleration from April's 0.53% and 0.55% readings. Auto insurance, another persistent source of upward pressure, is forecast to decline 0.1% in May, according to Goldman Sachs' online pricing model.

Used car prices are expected flat to slightly negative, while new cars may rise just 0.1%. The combination means that three of the most stubborn contributors to core inflation over the past two years — shelter, auto insurance and used cars — are all flashing cooler signals simultaneously.

Not every core component is cooperating. Airline tickets are rising, and Deutsche Bank notes that import prices point to continued strength in IT goods prices, driven by elevated global memory chip costs. UBS raised its non-rent core services forecast to 0.21% from 0.17% after S&P Global's services output price diffusion index hit its second-highest level since 2009, excluding pandemic anomalies.

What this means for the Fed and markets

Inflation swap markets are pricing headline CPI at 4.27% to 4.28%, slightly above the Bloomberg survey median of 4.2%. Morgan Stanley strategist Molly Nickolin found that swap pricing has correctly predicted the direction of year-over-year CPI in 9 of the past 12 releases. The current 0.48 standard deviation upside bias historically translates to a 0.14% gain in the DXY dollar index within one hour of release.

The last time headline CPI exceeded 4% was May 2023, at the tail end of the 2022-2023 inflation spike. That episode preceded a prolonged period of elevated Fed rates and a 7% pullback in the S&P 500 over the following two months. The current context differs: the energy shock is supply-driven rather than demand-driven, and core inflation is trending in the opposite direction.

For Fed Chair Warsh, the May CPI presents a communications challenge. A headline above 4% will fuel public inflation expectations — the University of Michigan survey already shows consumers expect 4.8% inflation over the next year — even if the core reading supports a patient approach. Deutsche Bank's long-term forecast sees energy inflation remaining above 10% year over year into early 2027 before turning negative, while core services inflation excluding shelter stays above 3% for an extended period.

The most likely scenario, according to JPMorgan Market Intelligence, is core CPI rising 0.25% to 0.3% month over month, which would put the S&P 500 in a range of down 0.5% to up 0.75%. A core reading above 0.35% would trigger a 2% to 3% selloff. A reading at 0.2% or below would fuel a 1.5% to 2% rally. "We view this print as 'good news is good news' and 'bad news is bad news,'" JPMorgan wrote.

This article is for informational purposes only and does not constitute investment advice.