US headline CPI inflation slows but core rate sticks

US headline CPI inflation was 6.5% year-on-year in December (consensus: 6.5%), compared to 7.1% in November. On a monthly basis CPI decreased -0.1% (consensus: -0.1%) compared to a 0.1% rise last month. The index for gasoline was by far the largest contributor to the monthly decrease, more than offsetting increases in shelter indexes.

Core CPI inflation, which excludes food and energy, came in at 5.7% (consensus: 5.7%) year-on-year, which compares to a 6% in November. On a monthly basis, core CPI rose 0.3% (consensus: 0.3%), versus 0.2% rise in November.

Rob Clarry, Investment Strategist at wealth manager Evelyn Partners says that with headline inflation continuing to decelerate, market attention will now turn to the all-important question: what does this mean for the Federal Reserve’s tightening cycle?

“Taking the Fed at face value, one might expect to see more interest hikes than currently being priced by markets (25bps in Feb and 25bps in March). Federal Open Market Committee (FOMC) members have continued to sound hawkish, with the latest FOMC minutes highlighting their displeasure at the recent loosening in financial markets conditions, which they believe will damage their attempts to bring inflation back towards target.

“Moreover, today’s inflation report provided a mixed picture with regards to the three inflation indicators that Jay Powell is following. Goods prices continued to fall but core services and housing inflation remained resilient. Core services excluding shelter gained 0.25% month-on-month (MoM), against 0.12% in November. Similarly, shelter shows no sign of abating and gained 0.8% MoM (vs 0.6%) in November.

“But on the other hand, a series of papers have recently been published by the regional Fed banks which have adopted a more dovish tone. Most notably, analysis from the Federal Reserve Bank of Philadelphia found that in aggregate 10,500 net new jobs were added to the economy in Q2’22, instead of the 1,047,000 jobs estimated by the Bureau of Labor Statistics’ (BLS) Current Employment Statistics (CES).

"While the Cleveland Fed constructed a new, timelier, index to measure rental prices. The new measure was found to lead the BLS measure (used by the Fed) by four quarters and estimates that annual CPI rent inflation will peak in Q1/Q2’23. Given that rent is the largest CPI component, this has major implications for monetary policy. Could this new data provide some cover for the Fed to announce a pause in the first quarter?

“Either way, in the near term we expect the Fed will continue to remain data-dependent given the challenges in accurately forecasting CPI. It’s unlikely they will telegraph ‘the pause’ in advance as they will want to avoid further loosening in financial conditions.

“With inflation data consistent with expectations, markets continue to price the Fed funds rate to peak at c.5% in March 2023; US equity futures are rallying.

“In conclusion, today’s report provided more evidence that US inflation is slowing, although components of core inflation continue to look ‘sticky’.  As the impact of interest rate hikes start feeding through into the real economy, we expect US economic activity to remain below trend next year.”