December CPI: Core Inflation Stabilizes – What It May Mean For Fed Policy (DJI)

Though the inflation rate is still above the Federal Reserve’s (“Fed”) policy target, overall inflationary trends appear to be stabilizing.

The Labor Department reported Thursday that the consumer-price index (“CPI”) rose 3.4% in December from a year earlier, up from November but still within a reasonable margin of consensus estimates. On the month, prices were up 0.3%, also ahead of expectations.

Excluding volatile food and energy prices, the core CPI increased 0.3% on the month and 3.9% from a year ago. This was more in-line with expectations. It was also the first time that the core rate fell below 4% since May 2021.

A degree of concern ahead of today’s release could have been warranted, given last week’s hotter than expected payroll figures. Investors could soak in the good news that inflation remains largely in-line with market expectations.

All three major stock indexes ticked lower Thursday after the inflation data. The Dow Jones Industrial Average (DJI) was down about 30 points in the pre-market trading hours, while the S&P (SP500) and tech-heavy Nasdaq Composite (NDX) were more flat. The benchmark 10-year Treasury note also inched up to 4.04%.

While the report could be viewed in a positive light, I do not believe it will materially alter the direction of Fed policy in the near term. Here’s what else investors can take away from the December CPI report.

December CPI Highlights

Among the kitchen table items, consumers could breathe some sigh of relief in gasoline prices. According to AAA, gas prices have continued to tick lower in 2024. And at present, the national average stands at about $3.08. While still above pre-pandemic levels, pricing is still at its lowest point since June 2021.

The lower prices at the pump provide confidence that fuel could continue providing an offset to overall inflation in the periods ahead. While gasoline prices rose 0.2% on the month following a decline of 6% in November. The YOY energy index still fell 2% in 2023.

This decline offset increases elsewhere, such as in transportation, which was up 9.7% in 2023 due primarily to vehicle ownership costs, such as maintenance and repairs. On a twelve-month basis, vehicle repairs and insurance were up a respective 7.1% and 20.3%. This includes another gain in December of 1.5% in insurance, with a slight reprieve of 0.3% in repairs. Travelers were afforded some relief in the form of rentals and airfares, which were down 12.1% and 9.4% during the year.

Though food prices remain high, the pace of growth in the volatile index continues to trail core prices, which are growing at under 4% per year. In December, the index for food at home rose 0.1% over the month, while the index for food away from home rose 0.3%. In individual categories, consumers appear to have received significant reprieve in breakfast cereals, as the line item decreased 2.4%, the largest such decrease since 2007.

Elsewhere, in the automotive sector, the used cars and trucks index continued its upward trend, up another 0.5% in December after logging its first increase in five months in November.

And while the index for shelter continued to rise, with the owners’ equivalent rising 0.5% on the month, the line item is impacted by its lagging nature. More leading indicators, such as Zillow’s Asking Rent Report suggest owner’s equivalent may track lower in the months ahead.

Consumer CPI Expectations

Lower gasoline prices and the notable overall decline in headline CPI since mid-2022 continues to shape consumer inflation expectations in a positive way. According to the New York Fed’s December Survey of Consumer Expectations, short-term expectations have declined to the lowest level in three years. In the one-year-ahead period, inflation expectations declined 40 basis points to 3.0%.

Expectations for the medium to longer-term horizon, however, remain stickier. Over the past year, expectations have been set around the mid to upper 2% range in the three to five-year-ahead periods. In terms of Fed policy, it is these longer-term views that are likely a critical element of their interest rate position.

After all, inflation expectations could become self-fulfilling. Therefore, a reduction in the longer horizon expectations to the low 2% range could provide the Fed with greater justification in enacting a policy shift.

Fed Policy Implications

Most observers of monetary policy expect a pivot to easing conditions in 2024. The December CPI report likely provides consistency to the viewpoint.

Following today’s release, the CME FedWatch tool is projecting a probability of approximately 65% that the Fed will lower the benchmark range to 5.00%-5.25%.

I am less optimistic that a cut will occur as soon as March. In my view, easing is more likely to occur towards the back half of 2024. While inflationary pressures have been on the mend, they remain sticky in important line items, such as insurance. Potentially self-fulfilling medium to long-term consumer expectations also remain above target.

The shelter component also continues to contribute significantly to the headline rate. But in this category, it’s not a question of if shelter’s contribution begins to decline; rather, it’s when. In prior coverage, I noted the dynamics surrounding shelter and have pointed to the leading indicator in Zillow’s Asking Rent Report as support. Today, I continue to maintain the view that the owner’s equivalent component of shelter will provide a meaningful downward draft to the headline inflation rate in the periods ahead.

Despite the rosy expectations among many, some are less hesitant to rule out the continuance of tighter policy. Nomura strategist, Charlie McElligot, for example, recently warned that current progress on inflation could be reversed if policy isn’t sufficiently tight enough. Given the unexpected report surrounding the rise in payrolls last week, McElligot’s caution appears well warranted.

December CPI Final Takeaways

Today’s CPI report is unlikely to alter the near-term interest rate trajectory. The FOMC is set to meet later this month. And heading in, most Fed officials have penciled in at least three rate cuts this year. While the December CPI reading affirms the view that inflationary pressures are on the decline, most expect the first rate cut to occur in March. Expectations for a cut sooner than that would likely be wishful thinking.

Though the labor market cooled significantly in the back half of 2023, recent payroll data, including wage growth, has tracked ahead of expectations. This could ultimately feed into services-based inflation, keeping the core rate even stickier than anticipated. Medium to long-term inflation expectations have ticked lower but remain elevated. Officials are, therefore, unlikely to be in a hurry to loosen policy.

Still, the December CPI continued to paint a promising picture of inflation, a picture that likely could support a normalization of Fed policy in the back half of the calendar year.