Stalled improvement in the December consumer price index appears to be the growing consensus among policymakers and investors as they await turn-of-the-year price increases.
The CPI data affirmed the growing inclination at the Fed that any further rate cuts—if there are any at all this year— should be postponed until the second half of the year.
The expected adoption of expansionary fiscal policies, as well as greater restrictions on immigration, are pointing toward more upward pressure on prices. All of these factors suggest that the Federal Reserve is at or near the end of its rate-cutting cycle as long-term yields approach 5%.
The consumer price index in December increased by 0.4% on the month and by 2.9% on a year-ago basis.
The gains were driven by increases of 2.6% in energy prices, 4.4% in gasoline costs, and 1.2% in used autos and trucks. Core inflation increased by 0.2% on the month and by 3.2% from a year ago. The increase in energy prices accounted for 40% of the CPI’s rise in December.
Investors are pricing in higher yields as inflation remains sticky and with the expectation of expansionary fiscal policies. Such policies will dampen risk taking across the economy and weigh heavy on fixed business investment and the housing sector.
Policy implications
The December CPI data affirmed the growing inclination at the Federal Reserve that any further rate cuts—if there are any cuts at all this year— should be postponed until the second half of the year.
This view is aligned with our call for two 25 basis-point rate cuts this year, with one in June and another in December.
But before making any decision on rates, central bankers will want to get a sense of the impact of higher tariffs and tighter immigration policies.
While we are confident that the year-ago metrics will look much better this spring, the underlying pace of inflation looks to be in the 2.5% to 3% range.
If that pace is sustained over time, it will alter the de-facto 2% inflation target among investors whether the Fed likes it or not.
We have made the case since the beginning of the inflation shock in 2021 that one casualty would be the Fed’s 2% inflation target.
The Fed will not speak of it in public, but it is increasingly clear that the 2% target needs to be lifted to a range between 2.5% and 3%. Arguments for a 3% to 4% target can be made as the end of secular stagnation transitions through a regime change that features an intense competition for capital between the private and public sectors.
The data
Top-line inflation was driven by a combination of increasing energy and transportation prices while food, shelter and services excluding energy all increased by 0.3% on the month and by 0.2%, 4.6% and 4.4%, respectively, on a year-ago basis.
The policy-sensitive owners’ equivalent rent advanced by 0.3% on the month and by 4.4% on the year, which is not conducive to arguments that the Fed needs to reduce rates in the first half of the year.
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Food at home rose by 0.3% on the month as was food away from home. The production of eggs, which are in short supply because of avian flu, advanced by 3.1% in December.
Electricity prices advanced by 0.3% on the month, apparel rose by 0.1%, medical care commodities were flat and medical care services increased by 0.2%. Transportation services increased by 0.5% in December.
The takeaway
While we welcomed a modest deceleration in core CPI, which excludes the more volatile food and energy components, once one digs beneath the headline figures, the data all points to sticky inflation in both the service sector and in housing.
This data in our estimation is not well aligned with arguments for near-term rate cuts as the aggregate demand driven by consumer spending continues to support economic growth near 3%, which is well above the long-term trend of 1.8%.
Investors are quite clear that turn-of-the-year increases present upside risk to inflation before any potential relief will be observed this spring as more forgiving year-over-year comparisons kick in.
