Overall, while December CPI inflation was slightly stronger than expected, we still believe that inflation can reach 2% by the end of the year.
The December CPI report showed an unexpected bounce in inflation with headline CPI rising 0.3% m/m (consensus 0.2%) and the year-over-year rate rising to 3.4% (consensus 3.2%). As disinflation is a key pillar of the market’s expectation for a soft landing, any resurgence in inflation would threaten that outlook. However, we don’t see much reason to worry about an inflation rebound and still expect the U.S. economy to return to roughly 2% inflation by the end of this year. Still, the unseasonable warmth of this report does splash some cold water on expectations for Fed policy easing beginning as soon as March.
Disinflation appears well underway for three key reasons:
- Shelter prices still have to turn. Over half of the monthly increase in headline CPI came from shelter prices which accelerated slightly this month, and if you strip out shelter inflation from core CPI, it rose just 2.2% y/y. Increased housing supply and declines in Zillow’s Rent Index suggest further declines in this measure ahead. A record-high 1MM+ multi-family housing units have been under construction in recent months and actual rents on new leases have increased at a modest 2.0% annualized rate over the last 6 months according to Zillow. While computational differences in the CPI measurement of rents versus Zillow creates significant lag and greater volatility (i.e., CPI splits their sample into 6 cohorts questioned twice per year, so the data is not continuous), over time this noise should fade and better reflect the slowing in the rate of increase in the Zillow rent data.
- Supply chains are restored and demand pressures fading. Core goods prices were flat as falling prices for home furniture and prescription drugs offset an uptick in car prices, which we expect will reverse in the coming months. The global vendor delivery index confirms supply chains have healed significantly while disruptions in the Middle East have so far failed to boost energy prices in a significant way.
- Auto insurance gains unlikely to be sustained and other services inflation should fade. Core services excluding shelter remained elevated in December with strong gains in medical care services (+0.7%) and a bounce in airline fares (+1.0%). Auto insurance, the key driver of inflation in this category, is up an astonishing 20.3% y/y. This year, auto insurers justified large policy increases by noting increased prices for vehicles, repair costs and heightened accident rates. However, this pace is highly unlikely to be sustained in 2024 and once policy rates roll over, a sharp drop in the year-over-year increase seems inevitable. Elsewhere, abating wage pressures as shown by declines in the JOLTS quits rate should dampen services inflation.
Moreover, the Fed’s preferred measure of inflation, the personal consumption deflator (PCE) should see continued moderation to 3.0% y/y in December with core services ex-housing rising just 0.2% m/m in December from 0.1% m/m last month. It’s worth emphasizing that this focus measure for the Fed, “super-core” services inflation, has been decelerating since late-2022 and its 3m/3m annualized pace has fallen to 2.9% as of November from 5.8% in Oct. 2022.
Overall, while December CPI inflation was slightly stronger than expected, we still believe that inflation can reach 2% by the end of the year, as shown by the chart, and this expectation is consistent with the Fed shifting towards rate cuts by this summer. That said, the hotter jobs report and CPI report suggest that the market pricing in over a 60% chance of a March rate cut may be premature. It’s likely investors will have to wait until later this spring for Fed officials to gain the confidence that the economic data warrants policy easing.