November CPI: Easing inflation amid surging housing costs poses dilemma for Fed

On first sight, the U.S. November consumer price index would suggest relief among policymakers following the second straight inflation report that came in lower than expected. With the top-line figure easing to a 7.1% annual increase and core inflation falling to 6% on a year-ago basis, the data released Tuesday by the Labor Department is both welcome and constructive. But it’s not all so rosy. The sharp 3.4% decline in goods costs on a three-month average annualized pace that dampened overall inflation stands in contrast with the 8.9% increase in housing costs, all of which poses quite a dilemma for the Federal Reserve. The major factors like commodities, energy and goods that have caused inflation to spike over the past two years are easing, while housing and service inflation, which feeds into wage pressures, continue to climb. Those increases suggest a continuation of efforts to restore price stability. The central bank is inching toward a monumental decision around whether to continue hiking the policy rate into a recession that is widely expected to begin next year. That policy decision will largely determine the depth and duration of the downturn. There is still much heavy lifting to be done by the Federal Reserve in its efforts to restore price stability. Early next year, the central bank will have to decide whether to pause its rate hikes just as past increases are taking effect. Falling commodity, energy and goods costs continue to put downward pressure on top-line costs, and falling airline fares and medical care costs are restraining increasing service costs. Yet it would be a giant misnomer to refer to a 7.1% inflation rate as disinflation with wages and housing costs still rising. The major drivers of inflation over the past two years are easing as the cost of goods and transportation come off the boil. But shelter costs increased by 0.6% on the month and owners’ equivalent rent increased by 0.7% on the month, up from the 0.6% gain last month. Both increased by 7.1% on a year-ago basis, and it is clear that housing continues to be the major driver of inflation.

Policy takeaway

The November inflation data will not alter the Fed’s next policy decision, which will be published on Wednesday but will shape the January and March decisions. We expect a 50 basis-point increase this week when the Federal Open Market Committee meets and another 50 basis-point hike at its January meeting. While the easing in commodities, energy and goods costs are all encouraging and will prompt discussion of a 25 basis-point hike at the January meeting, the elevated shelter costs and the likely direction of wage costs at year end, when wages are traditionally higher, implies that another 50 basis-point hike in January is warranted. It is simply too early in the inflationary cycle to pull back on efforts to restore price stability given the direction of the policy-sensitive owners’ equivalent rent and wages.

Beneath the headline

The top-line CPI increased by 0.1% on the month and by 7.1% on a year-ago basis, while core inflation, which excludes more volatile food and energy costs, increased by 0.2% on the month and by 6% annually. The good news is that energy costs declined by 1.6% on the month, used cars and trucks fell by 2.9%, airline fares dropped by 3%, medical care eased by 0.5% and commodities dropped by 0.3% in November. The bad news is that shelter costs increased by 0.6% on the month and owners’ equivalent rent increased by 0.7%, up from the 0.6% gain last month. Just as important, service costs increased by 0.3% and were up by 7.2% on a year-ago basis. Pricing pressure inside the service sector looks to be roughly 6% on a three-month annualized basis, and that will play into the upcoming series of important Fed policy decisions. Food and beverage costs increased by 0.5% on the month and by 10.3% from one year ago. Apparel costs increased by 0.2% on the month, transportation costs fell by 1.1%, the cost of new vehicles was flat, recreation prices advanced by 0.5% and education costs increased by 0.3%

The takeaway

Inflation peaked earlier this year and continues to ease at a modest pace. Base effects, or comparisons to a year ago, will continue to shape the inflation outlook through much of next year especially once the year-over-year comparisons in the energy complex dampen top-line inflation. Yet surging housing costs and the lagging impact of rising service costs on wages are likely to increase over the next few months. That, in turn, will put pressure on policymakers not to prematurely pull back on their efforts to restore price stability. Price stability is a precondition of maximum sustainable employment and growth at the long-term trend of 1.8%. Such stability is in the interest of small and midsize firms in the real economy.