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    Instant Insights: CPI falling, but too early to declare victory

    Instant Insights: CPI falling, but too early to declare victory

    January 12, 2023 Fixed income
    CPI came in line with market expectations, and will likely spark debate within the Fed as to whether to implement another “downshift” in rate hikes next month.
    Headline CPI fell into deflation month-on-month for the first time since July, at -0.1% (or 6.5% year-on-year). Core CPI remained more stubborn, positive at 0.3% (or 5.7% year-on-year).
    Base effects will bring headline inflation materially lower in the first half but getting core back towards the Fed’s 2% target will be difficult. Although good progress, we see it as too early for the Fed to declare victory.
    Energy and goods prices tip headline CPI into month-on-month deflation
    Energy and goods prices (such as used cars) were the largest detractors (Table 1).
    Table 1: Energy and falling goods prices helped push headline CPI negative month-on-month
      Sticky Flexible Non-Core
      Health services Owners' Equivalent Rent Airfare Used Cars Apparel Food Energy
    12-month Average  0.3%  0.6%  2.4%  -0.8%  0.2%  0.8%  0.7%
    Jul-22 0.4% 0.6% -7.8% -0.4% -0.1% 1.1% -4.6%
    Aug-22 0.8% 0.7% -4.6%  -0.1%   0.2% 0.8% -5.0%
    Sep-22 1.0% 0.8% -0.8% -1.1% -0.3% 0.8% -2.1%
    Oct-22 -0.6% 0.6% -1.1% -2.4% -0.7% 0.6% 1.8%
    Nov-22 -0.7% 0.7% -3.0% -2.9% 0.2% 0.5% -1.6%
    Dec-22  0.1% 0.8% -3.1% -2.5% 0.5% 0.3% -4.5%

    Source: Bureau of Labor Statistics, January 2023

    Energy goods (including areas like fuel oil and motor fuel) contributed -0.5% to CPI, helping airfare decline -3.1% despite the winter storm causing holiday flight chaos. Whether energy has much downside left is in question, particularly with China’s economy reopening.

    Base effects are helping, but core CPI will remain stubborn

    Inflation accelerated around 12 months ago, meaning “base effects” are set to help reduce inflation until the summer.

    If we hold monthly CPI constant at the 6-month average, headline CPI would be expected to come close to 2% by June (Figure 1). Although, this would imply another 15% deflation in energy CPI, which we see as unlikely. Further, after positive base effects expire over the summer, a rebound in CPI cannot be ruled out in the fall.

    Core inflation is therefore the measure to watch and with base effects alone would only fall to 4.5% by June, using the same calculation.

    Figure 1: Core CPIwill be stubbornly above-target for the rest of the year 


    Source: Bureau of Labor Statistics, Insight calculations, January 2023

    The services component of core inflation will interest the Fed most

    Within Core CPI, services CPI is still running well above target, displaying an almost mirror image to the contribution of goods CPI (Figure 2).

    Figure 2: Core services inflation is still running hot


    Source: Bureau of Labor Statistics, Insight calculations, January 2023

    We think it is useful to break down Core services into three areas: shelter, medical services and the rest (Figure 3).

    Figure 3: Core services excluding shelter and medical services are emerging as the measure to watch


    Source: Bureau of Labor Statistics, Insight calculations, January 2023
    1) Core services excluding shelter and medical services
    This segment is of particular focus, as it has a higher sensitivity to wage growth and Chair Powell mentioned following the last FOMC meeting that the central bank is watching it closely.

    Encouragingly, its contribution to core services fell over the last month. Also encouraging is that this is consistent with wage growth showing tentative signs of trending down, with the average hourly earnings at 4.6% pa last month, the lowest since August 20211.

    Of course, we need to avoid jumping to conclusions, particularly as December was disruptive for areas such transportation services. We believe investors should continue to watch this measure closely.

    2) Shelter

    We have explored this in detail in previous Instant Insights, and shelter continued to accelerate in December, contributing 25bp to CPI overall.

    This is not a surprise to us, as we do expect shelter to peak until the end of Q1 and begin a slow descent until Q2. This view was endorsed by the Cleveland Fed, which published new rental indices last month, including a “New Tenant” index, which it sees as a ~9-month leading indicator of shelter CPI. That index peaked in June 2022.

    In the coming months, there may be some noise around shelter CPI with “Owners’ equivalent rent” undergoing a methodology change. While the net impact is somewhat uncertain, we do not expect it to disrupt the overall trend.
    3) Medical services
    Medical services was positive even though health insurance CPI continued to be a drag at -3.4% (we previously explored why this is likely to be the case until October due to its collection methodology). This trend will be of concern if it persists.

    Goods prices may have more room to fall

    Goods deflation may have been exacerbated by holiday season discounts. Toward the end of 2022, retail inventories to sales reached its highest levels since early 2021, meaning there may have been a push to clear excess stock.

    Business sentiment indicates that improving supply chains will continue to reduce pricing pressure. The “prices paid” component of the manufacturing ISM is currently at the lowest levels since the start of the pandemic. Further, an index of business inflation expectations for the year ahead, maintained by the Atlanta Fed, reached the lowest since summer 2021 (Figure 4).
    Figure 4: Business inflation expectations are moderating
    Used cars were the second-largest detractor in the entire index after energy CPI, contributing -0.1%. Prices for used cars are now 40% above pre-pandemic levels, from a height of 55%, indicating continued normalization.

    The main uncertainty is the impact of China’s reopening. On one hand, it is likely to improve global goods supply. On the other, it will likely increase global commodity demand, putting some upward pressure on goods prices as well.

    Encouraging, but too early to declare victory

    Slower inflation over H1 is to be expected, but the Fed can only rely on base effects and falling energy and goods prices for so long.

    Ultimately, core services CPI needs to fall. While there are some positive signs this month from non-shelter and non-medical services, we need more evidence that a declining trend is in place.

    Bringing headline CPI closer to 3% could be relatively easy, but bringing the stubborn Core CPI measure closer to the Fed’s 2% target will be much more difficult.

    The Fed is likely to continue to step down the size of future rate hikes at coming meetings but whether this inflation release is enough for them to opt for a 25bp hike instead of another 50bp hike at their February meeting remains to be seen. Market participants have consistently underestimated the Fed’s resolve to meet its forecast terminal rate and the Fed may need to send a stronger message that it intends to keep financial conditions tight.

    Inflation is falling, which is good news, but it is too early to declare victory.

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