This week’s December CPI inflation numbers have given heart to the stock market and bond investors. Headline CPI came in as expected, at 6.5% year-on-year, the sixth successive monthly fall. Core CPI fell to 5.7%, confirming a more recently established downward trend.
But a more complex picture emerges on a month-on-month basis, which shows more recent trends in prices. Headline CPI fell 0.1%, but core CPI rose 0.3%. The reason for this difference?
By sector, the 0.8% rise in shelter costs over the previous month, a vital component of the services sub-category within core inflation, dominated the core inflation number. But the 9.4% fall in gasoline is excluded from the core numbers. We shall come back to this.
Both stock and Treasury markets rallied in response to the data. The Fed is taming inflation, the argument goes, without having had to apply scorched-earth policies that would have destroyed the labour market and induced recession.
The market anticipates a mere 25bps rate hike at the next Fed meeting (January 31/February 1) after four consecutive 75bps increases.
Go easy on the champagne!
To the doves, some sort of nirvana (transcendent state’) may be approaching: a couple more moderate rate hikes from the Fed, then a ‘pivot’ in the year’s second half as it eases monetary policy. At the same time, headline CPI inflation drifts down towards the 2% Fed target.
Meanwhile, the underlying economy enjoys a soft landing, and a new economic cycle starts early next year.
But we should delay opening the champagne bottles. Because the continued strength in shelter, and other services, is increasingly important to headline CPI as energy and good inflation shrinks.
Services rose 0.5% (dominated by shelter and transportation) in December, up 7.5% yearly. And here is the worrying news. Services inflation is most sensitive to wage growth, which remains stubborn, supported by five-decade-low unemployment.
Doves might reply that the December average hourly wage growth did fall to 4.5% year-on-year. The retort is that the decline in recent months has been relatively slight, and at 4.5%, there remains plenty of scope for more inflation in services, such as shelter.
As we have said in our previous market commentaries, the scale and breadth of the current inflation cycle have consistently been underestimated by the Fed (and other central banks), as well as by investors. Given this, one’s natural instinct is perhaps to side with the caution of the bears.
The most recent Fed ‘dot chart’ shows that its rate-setting policy group, the FOMC, believes the Fed funds rate will peak at 5.1% in early 2024. It appears rash to bet that it will, instead, peak at 50pbs or 25bps lower by this May, as some of the doves indicate.
Only when average hourly wage growth has reduced significantly can we be sure that inflation in services will weaken and allow a fall in headline CPI to the Fed’s 2% target. This will then allow the Fed to pivot and ease monetary policy. We are not there yet.
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