Disinflationary currents

• Disinflation is gaining momentum as we enter 2023, giving the “all clear” for the Fed to ease off the rapid pace of monetary policy tightening. Headline Consumer Price Index (CPI) inflation cooled 0.6 percentage points (ppt) to 6.5% year over year (y/y) in December — now 2.6ppt below its June peak — while core inflation fell 0.3ppt to 5.7% — its lowest since the 6.6% peak in September.
• Sequential price momentum remains encouraging. Headline CPI fell 0.1% month over month (m/m) last month as energy prices declined 4.5% on a 9.4% plunge in gasoline prices (representing a 0.4ppt drag on headline CPI). Food prices only rose 0.3% — their softest gain since March 2021.
• Core CPI rose a moderate 0.3% m/m — well below the 0.5% m/m gain over the prior six months — with core goods prices falling 0.3% on the back of their second largest monthly decline in November. Core services prices rose 0.5% as shelter cost rose a surprisingly strong 0.8% — most likely their largest monthly increase for many months to come. Excluding shelter costs, we estimate core services prices were up only 0.1% on the month.
• This latest inflation reading along with the easing of wage growth to 4.6% y/y in December are very likely to favor a 25bps Fed rate hike at the next Federal Open Market Committee (FOMC) meeting. While this would be a notable step down from the rapid pace of monetary policy tightening over the course of 2022, the Fed will want to avoid signaling any intention of pausing the tightening cycle.
• Indeed, while disinflation is well underway, inflation remains historically elevated, and the current easing of financial conditions is challenging the Fed’s narrative that it will continue raising the federal funds rate above 5% and maintain elevated rates for the foreseeable future. We assume the Fed will continue to favor hawkish communication to offset the easing of financial conditions.
• Still, we remain of the opinion that the Fed will only raise rates twice by 25 basis points (bps) in early 2023 and that it will pause its tightening cycle at 4.75%–5.00%. We believe a couple of rate cuts remain a distinct possibility in late 2023 as a recalibration exercise.

A look into the details reveals that good prices fell 1.1% in December, thanks in large part to a plunge in energy prices. Outside of energy, disinflationary forces are also gathering momentum. Used cars prices plunged 2.5% — the sixth consecutive monthly decline — while new car prices fell 0.1% — their first decline since January 2021. Used car prices are now 8.8% y/y lower than last year while new car price inflation has slowed from 13% last spring to 5.9% in December. Apparel prices rose 0.5% m/m with inflation down to 2.9% y/y from 5.8% at the end of 2021.

Meanwhile, services price rose 0.6% m/m, driven largely by higher shelter costs. Shelter cost rose 0.8% in December with rents rising 0.8% (tied for a record monthly rise) and owners’ equivalent rent also rising 0.8%. We anticipate housing cost pressures will ease significantly in the coming months on the back of a sharp pullback in housing demand. This slowdown may not be evident until the spring, but it will likely surprise many on the downside once it gets underway.

Restaurant prices rose 0.4% on the month — well below the average 0.9% monthly gain in Q3 — despite the lagged pass-through from higher food prices and labor costs. Hotel prices rebounded 1.7% while transportation services prices rose 0.2% despite a 3.1% drop in airline fares and a 1.6% decline in car rental prices.

Fed Chair Jerome Powell has repeatedly stressed that core services inflation (excluding shelter cost inflation) is potentially the most important determinant for inflation — given the ongoing goods price disinflation and anticipated shelter cost deflation. While many Fed policymakers have noted that sticky wage growth is likely to support persistent core services inflation, our discussions with business executives indicate that most envision reduced hiring along with wage growth compression as alternatives to layoffs in order to keep a lid on labor costs.