US consumers are getting more relief on the inflation front, and more importantly for the markets, the outlook appears to be getting better as well.
Over the last 12 months, overall inflation increased 6.5% in December, down from 7.1% in November. Excluding food and energy, prices rose 5.7% from year-ago levels. While this still above the Fed’s long-term inflation target of 2% on an annual basis, its the lowest annual increase in more than a year – and below the levels seen in summer.
“The report provides further evidence that inflation is normalising,” says Preston Caldwell, Morningstar’s chief US economist. “We expect price slowdowns to continue in 2023 and beyond.”
The Bureau of Labor Statistics reported an overall decline of 0.1% in the US Consumer Price Index for December, in line with consensus estimates, for the first negative month-on-month reading of its kind since May 2020. The decline was led by gasoline, used cars, and airfare prices. Food and housing prices both increased for the month.
Core CPI, which excludes the volatile food and energy components, rose 0.3% in December (also in line with forecasts) after rising 0.2% in November. The increase in core inflation in the December report was driven mainly by housing costs.
The overarching trend, Caldwell says, “has been emphatically to the downside”. In the last three months, core inflation has averaged a 3.1% annualised growth rate, down sharply from the about 6% rate averaged from 2021 through most of 2022. By this measure, he says, “inflation is now within eyeshot of the Fed’s 2% target”.
“The decline in core inflation is even more astounding when we strip out food, energy, and shelter prices,” Caldwell says. That’s an annualised decline of 0.9% in prices over the past three months, he notes.
Housing Inflation Should Subside
Housing prices have continued to rise quickly, but Caldwell says that the rise in housing prices is driven entirely by the lagged response of the housing index: “Market rents and housing prices were soaring in 2021 and early 2022, but the trend has reversed in recent months.”
He expects housing inflation to subside further in 2023, providing another meaningful downward contribution to core CPI.
Within core services, Caldwell says the key question is what will happen to prices excluding healthcare and housing, which averaged a 5% annualised rate of inflation as of December. “If wage inflation remains moderate, near the 4% rate of private wage growth seen in recent months, inflation in this category should come down,” he says.
For now, the trending decline in inflation is driven by just a few categories – stickier areas will need more time.
“The decline in auto prices still has another two to three years to play out, given that prices are still well above trend,” Caldwell says. “We expect deflation to spread to other categories of core goods as well.”
In December, food prices rose 0.3% over the month as the food at home index rose 0.2%. Gasoline prices declined, driving a fall in energy prices of 4.5%.
Fed Rate Hike Pause Looking Likely
The December CPI report, coming on the heels of previous better readings on inflation, appears to give the Fed some breathing room and allow it to soon pause its aggressive series of interest-rate increases.
“This inflation report – In conjunction with data showing moderating wage growth – essentially guarantees that the Fed will opt for just a 0.25-percentage-point increase in the federal-funds rate in its upcoming February meeting,” Caldwell says. That’s a smaller hike than the 0.5 percentage points seen in December and the 0.75-percentage-point hikes deployed at the four prior meetings.
After that, Caldwell expects the Fed to stop hiking interest rates at its March meeting, “dependent on two more months of data showing much-improved inflation”.
The market’s expectations have solidified for a quarter-point increase in the federal-funds rate at the upcoming February meeting. According to the CME FedWatch Tool, there’s a 91.2% chance for a 0.25-percentage-point rate hike at February’s meeting and just an 8.8% chance of a larger 0.50-percentage-point hike. A month ago, most expected the Fed to raise rates by a more aggressive half-percentage-point amount.
Expectations of what’s further down the road have mostly held steady following the report. The majority of market participants see the federal-funds rate reaching 5.0% at the March meeting and staying there through most of the year.
