Inflation increased by 2.7% on an annual basis in December, bringing to close a year of noise in the data caused by trade taxes, the extended government shutdown and methodological quirks introduced by the Bureau of Labor Statistics.
The result of these distortions was a lower reading in the November consumer price index than otherwise would have been the case, which will eventually reverse.
While we think that these distortions began to ease in the December data, they will not completely reverse until this spring.
Ultimately the consumer price index will go round trip from 3% in October to 2.7% in November to 3% in April.
Perhaps the most important takeaway is that the window on a near-term Fed rate cut is rapidly closing. Investors are now pricing in only a 5% probability of a January rate cut and an 18% probability of a cut at the March meeting.
We think that the best opportunity for a rate cut is at the June meeting, where one would have thought a new Federal Reserve chair with a dovish bias would take over.
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With growing uncertainty around whether any nominee to replace Fed Chair Jerome Powell can get out of the Senate Banking Committee, that likelihood is now in doubt. Under such conditions, the probability of a June rate cut is now at 50%.
In addition, expansionary fiscal policies will bolster disposable income. Because of large tax cuts that took effect on Jan. 1, we think that economic growth in the first half of the year will arrive close to 3%, which will raise further questions around why a rate cut is warranted when the economy is running hot and well above the long-term growth trend of 1.8%.
The data
Inflation increased by 0.3% in the top line and by 0.2% in the core excluding food and energy in December. The year-ago metrics advanced by 2.7% and 2.6%, respectively.
The primary reason for the top-line data arriving below consensus was a 0.5% monthly decline in gasoline and a 1.1% drop in the price of used cars and trucks.
Beyond those two areas, evidence of rising costs was clear across the report.
Service sector costs increased by 0.3% in December and by 3.3% from a year ago while services excluding energy advanced by 0.3% and 3%.
Housing data reflected the rebound in housing costs as data collection in many cities resumed by increasing by 0.4% monthly and by 3.6% annually.
Shelter costs jumped by 0.4% in December and by 3.2% for the year. The policy-sensitive owners’ equivalent rent increased by 0.3% for the month and by 3.4% over the year.
Fuels and utilities increased by 0.8%—a source of pain for households that argue they are caught in an affordability crisis—and by 6.7% from one year ago. Food costs rose by 0.7% monthly and by 3% annually.
Apparel prices increased by 0.6% for both December and for the year. Transportation costs were flat on the month and rose by 0.4% annually.
Airline fares increased by 5.2% in December but declined by 3.4% from a year ago while medical care advanced by 0.4% and 3.2%, respectively.
The takeaway
It will be at least April before distortions from the government shutdown and the BLS’s methodological quirks work through the system.
Top-line and core data will most likely move higher as the noise fades. So, it is best not to overinterpret the December data and it will be spring before we get a clean read on where inflation is.
Perhaps, more important, as the economy kicks into a higher gear and as inflation moves higher, the window on a near-term Federal Reserve rate cut is closing.
