U.S. core Consumer Price Index (CPI) inflation was firmer than expected in July, increasing 0.3% month-over-month, similar to June’s gain, and the year-over-year rate ticked up to 2.2%. We have been flagging the risk that businesses could pass on the higher costs associated with import tariffs more aggressively, and early evidence suggests this is happening. We now expect the year-over-year rate of core CPI to drift up to 2.5% over the next several months.

While the strong June and July readings are awkward for Federal Reserve officials, who are likely to cut rates again in September and possibly more later this year, we think they will look past it given that much of the firming is happening in retail goods categories subject to tariffs – and therefore temporary. Moreover, the news that the U.S. is removing certain products from the list subject to Chinese import tariffs set to go into effect on September 1, and delaying to December 15 tariffs on items that can’t be easily sourced from other countries – including cellphones, laptop computers, video game consoles, certain toys, computer monitors, and certain footwear and clothing items – could further ease related inflation concerns. With inflation expectations more or less anchored, the risk that tariffs kick off an inflationary spiral appears much lower than the downside risks to real growth from trade and tariff uncertainties and slower global growth.

Inflation marches on despite ‘Prime Day’ discounts

The firming in July came despite reports of broad-based sales promotions around Amazon Prime Day on July 15, with businesses appearing to pass on a greater portion of the higher goods import tariffs. The pace and magnitude of consumer price adjustments have been somewhat more aggressive following the May tariff announcements, prompting us to incorporate a somewhat higher rate of pass-through for the wider range of goods subject to tariffs after the “Tranche 4” announcement on August 1 (despite some products being removed from the list and the others delayed until December). We now expect retail goods inflation to reach 1% over the next several months – a pace that hasn’t been witnessed since early 2012.

Services categories hold firm

Meanwhile, core services prices gained 0.3% month-over-month, with support from solid gains in shelter services. Lower vacancy rates and the lagged effects of rising wages and higher interest rates (which make owning a home comparatively less affordable) are supporting housing inflation. Eventually, the more recent decline in rates and a slower pace of wage gains will help cool CPI-reported housing services inflation; however, based on the historical lags, inflation in these categories should hold firm over the next several quarters.

Medical, airfare, and lodging inflation was also firm. Price changes in lodging are notoriously volatile and tend to mean-revert over time, while the lower cost of jet fuel will moderate airfares over the coming months. However, the faster pace of medical services inflation should stick. Inflation in this category was notably weak in 2017 after lower payout rates from government-administered programs spilled over into private insurance payments. However, administrative changes in 2018 reduced the managed disinflation in Medicare and Medicaid prices and have allowed medical service providers to charge higher prices to private insurance.

Used car inflation stays strong after a price spike in June

While used car prices were strong in June and July, price trends in the wholesale auction market have since cooled, pointing to slower used car inflation over the next several months. Looking ahead to next year, the recent drop in steel prices should further moderate new and used car inflation.

Bottom line? We now expect the year-over-year rate of core CPI to reach 2.5% over the next several months, with businesses increasingly passing the cost of tariffs on to consumers. However, firmer inflation shouldn’t change the easing bias of Fed officials, who will likely be more worried about mounting downside risks to real economic growth. We expect the Fed to look past the recent price gains as it contemplates further interest rate cuts this year.

For more of PIMCO’s views on the complex drivers of inflation in the U.S. and globally, please visit our inflation page.

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Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.