A third straight month of improvement in top-line inflation data implies that conditions are moving in the direction where the Federal Reserve can consider further moderation in the pace of its rate hike campaign to restore price stability.
The tone and tenor of the data imply an underlying inflation rate slightly above 4%, an undeniably positive development for the Fed.
Top-line inflation declined by 0.1% on the month in December and increased by 6.5% on an annual basis, which is a deceleration from the 7.1% rate in November.
Core inflation increased by 0.3% on the month and by 5.7% from a year ago, down from 6% previously.
The primary catalysts for the improvement in the inflation data were sustained declines in overall goods prices. Used cars and truck prices declined by 2.5%, energy prices dropped by 4.5% and select data inside the service sector such as airfares declined by 3.1%.
The 9.4% decline in gasoline prices more than offset the 0.8% increase in the cost of shelter, which provided the necessary downward pressure on the top-line figure to result in December’s mild disinflation.
More impressively, the three-month average annualized pace of core inflation slowed to 3.1% from 4.3% previously. That decline should provide generous relief to policymakers concerned about overshooting in their efforts to prevent a wage-price spiral on the back of wage demands that reside near 5%.
Away from the catalysts behind the easing in inflation, service prices increased by 0.6% on the month and were up by 7.5% on a year-ago basis, while housing costs increased by 0.7% and by 8.1% on an annual basis.
The so-called “super-core” inflation measure, or service inflation excluding housing that feeds through to wage demands, increased by 2.2% on a three-month average annualized basis, down from 4.9% previously.
Core services excluding housing and medical care increased at a 5% three-month average annualized pace. Core services excluding housing, medical care and airfares rose at a 6.3% rate using that same metric.
Given that Federal Reserve Chairman Jerome Powell has cited this core data in his deliberations, it hints at a notable improvement in the overall inflation outlook. The Fed’s preferred metrics of wage inflation─the Employment Cost Index─will next be published with fourth-quarter data on Jan. 31, the day before the next policy decision is announced.
Policy considerations
A potential pause in rate increases is now a distinct possibility. The Fed raised its policy rate by 425 basis points over the past year and now has an opportunity to assess how the economy has absorbed those increases.
There is ample evidence that inflation is declining, and the outlook for the year is encouraging. For example, the spike in energy prices from a year ago will start to wear off, making comparisons for the annual rate of inflation easier. That will help drive down top-line and core inflation to near 4% by late summer.
While we still lean in the direction of a 50 basis-point hike at the Fed’s next policy meeting in two weeks, any decisions will be affected by the publication of the Employment Cost Index report.
Should that report reflect an easing in wage pressures from the 5% increase in the third quarter, then conditions will be ripe for a reduction in the pace of rate hikes. We think it would be appropriate for a potential pause to occur once the policy rate reaches a range between 5% and 5.25%.
The data
Food and beverage prices increased by 0.3% on the month and by 10.1% from a year ago. Egg production, which has been severely affected by the avian flu, rose by 11.1% on the month and has soared by nearly 60% from a year ago. Overall commodity costs declined by 1.1% in December and were up by 4.8% from a year ago.
Any breakout of the champagne for a victory over inflation should be tempered by the rising costs inside the food complex.
The cost of shelter increased by 0.8% and was up by 7.5% from a year ago. The policy-sensitive owners’ equivalent rent series increased by the same amount on a monthly and annual basis. Apparel costs increased by 0.5% and were up by 2.9% from a year ago.
New vehicle costs declined by 0.1% and were up by 5.9% over the past year. The cost of medical care increased by 0.1% and was up by 4% over the past 12 months.
The cost of recreation increased by 0.2% in December, and education and communication costs advanced by 0.1%.
The takeaway
Three straight months of improvement in inflation point to a near-term potential easing in the Fed’s policy hikes. Underlying inflation looks to be somewhere above 4%, which is more than double the Fed’s inflation target of 2%. That elevated rate should serve as a reality check for those calling for an immediate end to rate hikes.
While recent improvements in overall inflation are undeniable and we expect the top-line readings to ease considerably, all one has to do is look at the price of eggs to remind us of just how difficult the Fed’s task is.
