Price stability: Learn it, know it and love it because that is what the Federal Reserve will be talking about over the next two years as the central bank attempts to craft a soft landing following an increase in the Consumer Price Index to a 7% annual rate in December.
The Fed’s challenge over the next two years will be to craft a soft landing following the increase in inflation.
The Consumer Price Index data released on Friday, though, implies anything but stability. The core CPI, which excludes gasoline and food, increased 5.5% on a year-ago basis and was up 0.6% along with the 0.5% monthly increase in the top-line number.
Shelter costs, which are our primary concern with respect to public expectations of inflation, increased 0.5% on the month and were up 4.1% from a year ago. The policy-sensitive owners’ equivalent rent, which comprises 23.5% of the CPI, advanced 0.4% and was up 3.8% on a year-ago basis.
The top-line data, along with the cost of rents, will drive the Federal Reserve’s public discussion, expectations and policy decisions this year, which will have three rate hikes and possibly four.
But there are tentative signs that the major drivers of the price increases have eased. Energy costs declined 0.4% on the month and gasoline prices fell 0.5%. Services, which increased 0.4% in November and 0.6% in October, moderated to a 0.3% increase and were up 4% on the year.
Given that most of the economy is based in services, the data continues to imply that most of the price increases are in the industrial and transportation sector. The cost of transportation increased 0.8% on the month, driven by a 1% increase in the cost of new vehicles and a 3.5% rise in the price of used cars and trucks.
Avoiding entrenched inflation
The primary policy takeaway is that the Federal Reserve is now on a path to prevent inflation from becoming embedded and entrenched in the economy. What is perhaps more interesting is the idea that interest rate hikes and balance-sheet drawdowns by the Fed can address the pandemic-induced supply chain disruptions, which are the primary cause of the inflation.
The Federal Reserve cannot do much about those disruptions, so its primary policy aim will be to keep market-based expectations of inflation over the medium to long term near the Fed’s current target of 2%.
Firm managers and investors should anticipate an extended period of hawkish talk and policy positioning out of the central bank to support the three rate hikes—beginning in March—that are fully priced into the market and a fourth that now has a 90% probability.
What will be of paramount concern is if the Fed will meet market expectations as inflation comes back to earth and growth begins to ease later this year.
Once the new appointments to the Federal Reserve are in place by midyear—and they will almost certainly be of the dovish variety—that will most likely put in doubt the direction of the more hawkish policy. It would not be surprising if the market devolves into two camps: one that favors two hikes and another that favors four.
Inside the data
Food prices advanced 0.5% on the month and were up 6.3% over the past year. One interesting note inside the increase in food costs is that they were driven by rising cereals and cereal products costs, which increased 0.8% in contrast with the decline of 0.4% in the cost of meats, poultry, fish and eggs. Food away from home increased 0.6% in December.
Medical care increased 0.3% and was up 2.2% on a year-ago basis. Apparel costs jumped 1.7% and commodities increased 0.8% in December. Education and communications costs were flat, while recreation costs declined 0.2% on the month.
Household furnishings and supplies increased 1.3% in December, driven by windows and floor coverings that advanced 0.8%, furniture and beddings that increased 2%, appliances which jumped by 1% and other household furnishings that had a 0.9% increase on the month.