Fed Hike Likely, Despite Encouraging Inflation Numbers

December Consumer Price Index (CPI) Inflation data showed month-on-month deflation with prices falling 0.1%, primarily due to lower energy prices. However, despite the monthly decline, inflation is still running at 6.5% year-on-year compared to the U.S. Federal Reserve’s (Fed’s) 2% goal.

In addition, services inflation, which the Fed is watching closely, rose 0.5% for the month, driven by mainly by rising housing costs. Although inflation has eased since the summer, the Fed is expected to take a cautious approach, likely hike rates on February 1. A 0.25 percentage point rise in rates at that meeting, is viewed as most likely by bond markets.

December Inflation Data

December’s inflation data was broadly encouraging. Energy prices, falling 4.5% caused prices to decline overall for the month, but stripping out food and energy, prices rose 0.3% month-on-month, which is still a little higher than the Fed wants. Inflation has clearly trended lower since the summer, even if it’s still well above the Fed’s 2% objective.

The cost of many goods fell in December. Categories seeing monthly price declines included many commodities, cars and certain categories of household goods and clothing. Food prices, which were rising rapidly are still increasing, but at a slower 0.3% monthly rate as the cost of various foods such as various meats and produce fell in price month-on-month for December, notwithstanding a spike in the price of eggs.

Housing Costs

The main issue the Fed will have with the CPI report is rising services costs. This was mainly due to rising shelter costs. Shelter costs rose 0.8% for the month of December. However, unlike other elements of the CPI report, shelter costs have a lag of several months to current markets prices because of the calculation method used.

According to Zillow data housing costs have eased since the summer, and Zillow forecasts house prices to fall slightly on a 12-month view. If that forecast holds it could bring down inflation further, especially because housing costs are a major component of the CPI, and the only major category still rising strongly in price in the December report.

For now, housing is still showing double digit year-on-year increases on many estimates, but the slowing of house prices and the lag with which current housing costs are reflected in the CPI, could move the inflation rate lower as 2023 progresses.

What Will The Fed Do?

The Fed may be running out of things to worry about with inflation. Yes, annual inflation remains well above target, but the trend since the summer has been more encouraging than many expected.

Prices of goods are easing, commodities and energy have declined from peak levels. One remaining concern is that services prices are continuing to rise, but housing is a large part of this, and growth of house prices could slow further in the coming months.

The Fed may also point to wages rising at around 6% year-on-year according to the Atlanta Fed’s estimates, though even here, wage growth appears to have moderated since summer 2022. The Fed also worries that another inflation shock, such as the Ukraine war or supply chain issues could push inflation to unmanageable levels. As time passes, that scenario becomes less likely.

The Fed may well raise rates again in February, but recent inflation data has shown an encouraging trend, supporting the view that we’re close to the top of the interest-rate cycle. Many Fed policy-makers expect rates to top out at over 5% this year, but the market suspects that the Fed may not go that far.