Inflation Falls

The inflation picture continues to improve

All of the headline measures of consumer inflation for December came in exactly as expected.

·         The headline Consumer Price Index (CPI) fell -0.1% m/m, which was the first decline since the pandemic.

·         On a y/y basis, CPI slowed sharply to 6.5%, down from last month’s 7.1%.

·         Core CPI, which excludes volatile food and energy prices, rose +0.3% m/m

·         On a y/y basis, core CPI slowed to 5.7%, down from last month’s 6.0%.

Much of the fall in the monthly headline came from sharp drops in both gasoline and fuel oil, which is home heating oil and diesel fuel (among other distillates). The second chart is the y/y change in inflation and shows that two categories which have strongly contributed to headline inflation, gasoline, and used cars, are now blessedly negative. On the contrary, fuel oil remains very high.

CPI Chart
CPI Chart
The slowdown in inflation is evident in the charts below. The first chart simply shows the y/y growth rates on the headline and core CPIs, and the slowing is particularly notable in the headline represented by the blue line. It has gone from a 40-year peak of 9.1% in June of 2022 to 6.5% in December, a 2.6% decline. The core rate as represented by the brown line has fallen from its September peak of 6.6% to 5.7% or only a 0.9% decline - much less than the drop in the headline. The second chart again shows the headline with the blue line being the y/y rate, and the columns being the month/month rate. Note that December’s -0.1% is the first decline since the pandemic. The third chart shows the y/y and m/m changes for the core CPI. Note that the m/m rate in December was higher than in both November and October. In addition, although the y/y rate did slow in December, it has been bound in a range between 5.7% and 6.6% over the last nine months. In other words, core inflation remains sticky. This is a problem for the Fed because the core measure is in theory easier to influence than food or energy prices. For instance, egg prices have recently soared due to an outbreak of avian flu. Oil and gasoline prices can be affected by many events such as surges in supply and demand (around Covid for example), changes in OPEC policy, refinery shutdowns, weather, etc.  Events like those are essentially out of the Fed’s influence, but in theory, the core CPI is not.
CPI Chart
CPI Chart
CPI Chart
Core goods which account for 21% of the CPI continue to decline. However, core services, which account for 57% of the index remain sticky and continue to rise. Shelter prices, which account for 39% of the index are also sticky. In addition, shelter prices lag market housing prices by as much as a year because of the methodology used, so they will maintain upward pressure on the headline for some time.
CPI Chart
Shelter Prices
And with December CPI falling -0.1%, real, after inflation wages rose 0.4% m/m, and on a y/y basis are climbing back from the pit of -3.1% set in June of 2022 to -1.9% in December
Real hourly Wages

Thus we see that while services and shelter are still bothersome, real wages are improving, and the headline, the core, and the core goods CPI measures are all definitively turning down.

So should the Fed perhaps pause on its journey of hiking rates? The signs in this report look like inflation is being tamed. And since monetary policy takes three to five quarters to have a full impact, there is still plenty of inflation-killing ammunition which has already been shot but just hasn’t gotten to the target yet.

Furthermore, there are many signs that the economy is quite likely to be heading into a recession. We are seeing falling retail sales, shrinking real disposable personal income, slowing real consumption expenditures, consumers worrying more about the future than the present, slowing in the labor market, a collapsing housing market, weak ISM reports, and of course the inverted yield curve. It’s a gruesome list. And that inflation-killing ammunition is headed directly at the economy too. Maybe the Fed should take a breather?

It won’t. Chairman Powell has been very explicit, vocal, and forceful about the Fed’s commitment to raise rates high and keep them there until the Fed is sure it has defeated inflation.

At the Fed’s press conference at the end of the December meeting, Powell said:

·         “Historical experience cautions strongly against prematurely loosening policy. I wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2% in a sustained way,” 

·         “There’s an expectation really that the … services inflation will not move down so quickly so that we’ll have to stay at it,”

·         “So we may have to raise rates higher to get to where we want to go and that’s really why we’re writing down those high rates and why we’re expecting that they will have to remain high for a time.”

·         “It will take substantially more evidence (than the easing CPI) to have confidence that inflation is on a sustained downward”

·         “Price pressures remain evident across a broad range of goods and services”

The Federal Reserve’s minutes of the December meeting were basically (my words): “Get out of the way, we are coming through and no you are not going to get your rate cuts this year.” Here is an actual quote:

·         “No participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023. Participants generally observed that a restrictive policy stance would need to be maintained until the incoming data provided confidence that inflation was on a sustained downward path to 2 percent, which was likely to take some time. In view of the persistent and unacceptably high level of inflation, several participants commented that historical experience cautions against prematurely loosening monetary policy.

·         And the Fed strongly suggested to the financial markets they’d better stop causing trouble with any over-optimism about, again, rate cuts in 2023: “…an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee’s reaction function, would complicate the Committee’s effort to restore price stability.”

An increase in the Fed Funds rate at the February 1st meeting is all but a certainty at this point, and there will very likely be another one at the March 22nd meeting unless the inflation picture improves much more rapidly and definitively than currently expected. The economy is in peril.

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