image image

    Instant Insights: We are continuing our descent

    Instant Insights: We are continuing our descent

    December 13, 2022 Fixed income

    For the second month in a row, inflation came in lower than expected. Headline CPI was 0.1% month-on-month and core CPI was 0.2%, taking the year-on-year figures to 7.1% (the lowest since last December) and 6% (the lowest since July).

    Most areas of the report offered good news, outside of the stubborn rental and food components (Table 1).

    Table 1: Outside of shelter and food components, most categories moved in the right direction for the Fed1

      Sticky Flexible Non-Core
      Health services Owners' Equivalent Rent Airfare Used Cars Apparel Food Energy
    12-month Average 0.4% 0.6% 2.8% -0.1% 0.3% 0.8% 1.2%
    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%


    There are three key reasons we are optimistic about CPI falling further next year: base effects, falling goods prices and potentially peaking rental inflation by Q2 2023. The Fed will also be watching non-shelter services, which also moved in the right direction this month.

    Base effects bode well for falling CPI into summer 2023

    This time last year, CPI accelerated particularly rapidly, from 5.4% last September to 7% by year end (the acceleration continued into summer 2022).

    As such, if inflation simply maintains recent trends it will fall to the 4-5% region by next summer (Figure 1).

    Figure 1: At current trends, base effects will take headline and core CPI closer to 4-5%2


    Untangling supply chains are helping to ease goods prices

    For the second month in a row, core goods prices were in deflation, this time at -0.4% month-on-month. Used car prices were the second largest negative contributor and leading indicators, such as the Manheim Used Car index, indicate that the bottom is not in, as the index fell -14.2%3 last month, its largest fall ever.

    New vehicle inflation also saw some relief at 0.04% month-on-month, the lowest since January, helped by untangling of supply chain pressures across the board (Figure 2).

    Figure 2: Untangling supply chains are helping to ease pressure on goods prices4


    The BLS estimates health insurance CPI, in large part, by calculating the growth in the ratio of insurer retained earnings to total premiums. However, the BLS only receives the data annually, primarily from the National Association of Insurance Commissioners (NAIC) and the California Department of Managed Health Care (DMHC) and spreads the impact over the course of the year.

    This took ~6bp off CPI month-on-month. Due to base effects, assuming a consistent 2.5% monthly drag over the next year (in line with the latest NAIC figures) health insurance CPI could fall below -20% year-on-year (Figure 3), into 2023, taking over ~40bp off year-on-year CPI by this time next year.

    Figure 3: Goods and services spending is still normalizing5


    We have consistently stressed the importance of the shelter component of inflation, which remained strong at 0.6% month-on-month (or 7.1% year-on-year), and was once again the largest positive contributor within the index.
    While we expect shelter to lead the index over the coming months as well, as we highlighted last month, we believe signs are pointing to a peak by Q2 2023. The Zillow rental index, a leading indicator, rose by 0.06% month-on-month in November, its slowest increase since June 20206.
    Health insurance, another sticky inflation measure, fell again (due to a measurement update we highlighted last month), at -4.3%, having come in at -4% last month. At this rate we expect it to subtract ~0.6% off CPI in 2023.

    Non-shelter services are also moving in the right direction

    The focus is now finally shifting to the other services sectors, such as transportation, recreational and education services.
    These areas are of particular importance to the Fed because they are sensitive to wage growth, which is running at ~5% according to the latest employment report and employment cost index, or at 6.4% based on an index maintained by the Atlanta Fed.
    Encouragingly, services excluding the rental component of shelter was narrowly negative at -0.01%, or +7.3% year-on-year (the lowest since July), but before declaring victory on inflation, we expect the central bank will still watch these categories closely given ongoing labor market tightness.

    Good news for the Fed, but it will be concerned about keeping financial conditions tight

    We expect the report will help the Fed justify a downshift in its monetary tightening efforts. We expect a 50bp hike at tomorrow’s meeting and for the Fed to guide to a higher terminal rate in the 5% region, while communicating that rates will remain elevated for some time.
    We expect the Fed will also be conscious about markets taking too dovish of a message away from the meeting, as it will need to keep financial conditions tight to keep inflation moving in the right direction.
    In general, we expect ongoing improvement in inflation but the path to 2% continues to be challenging.
    Back to top