December CPI Report: Consumer prices fall by 0.1%

The December Consumer Price Index (CPI) report was yet another in a string of encouraging reports on inflation. For the month, consumer prices declined overall by 0.1%, with energy and goods prices leading the decline. So-called “Core” inflation, which excludes volatile food and energy prices, has risen at a 3.1% annualized pace in the last three months, which is the slowest in over a year. Can inflation continue this downward trend? Here are our views on what comes next and how it might impact you.

Inflation slowing in all the right places

The December inflation report had similar patterns to November and October. The price of goods, e.g., any physical item you might buy in a store or online, declined. Services prices were held up only by the Shelter component, basically the cost of renting or owning a home. Because of the Labor Department’s technique to measure both items, the Shelter component tends to lag reality. For example, according to the Case Shiller Home Price index, the average price of a single-family house has declined by 2.4% since June. However, the home price component of the CPI has risen by 4.3% over the same period.

We know that reality is going to catch up with the Shelter component. Right now, the Shelter component is one of the fastest-rising segments in the CPI. However, it could soon be one of the slowest. As this happens, we believe Core CPI will continue its slowing trend.

Could inflation reignite?

Fundamentally, inflation stems from spending outpacing the production of goods and services. Or, to use economic terms, demand outpacing supply. Our confidence that inflation will keep slowing isn’t just about the technical impact of the Shelter component but rather the fact that consumer demand has subsided and looks unlikely to reaccelerate.

The chart below shows compares the growth in household spending¹ and total weekly earnings ². 

If we follow the sequence of the bars, it fits what has happened with inflation rather well. Inflation started its big acceleration in 2021, and we can see that both household spending (blue bar) and wage income (orange bar) were far above the pre-COVID trend. This is because the pace of spending overwhelmed the ability of the economy to supply. In the first nine months of 2022, the pace of income and spending were lower but still very elevated. Hence inflation remained high.

But if we look at the last three months of 2022, spending has slowed to be very similar to five years before the COVID period. Consequently, inflation has slowed too. We think that unless spending reaccelerates, there’s no reason to expect inflation to rebound. For spending to reaccelerate, wage growth would have to jump as well. After all, households can only spend what money they have. Again looking at the chart, wage income growth has slowed to pre-COVID levels, and if anything, the labor market seems to be cooling further. 

We believe this adds up to a durable trend. Inflation will follow the pattern of household spending, and there’s no reason to expect household spending to rebound to the inflationary pace of 2021 and early 2022.

Will the Fed be ready to pause?

For the last few months, we have suggested that the Federal Reserve could pause rate hikes as soon as March 2023. While this CPI report does not make that a guarantee, it certainly helps. 

Earlier, we mentioned that Core CPI has risen at a pace of 3.1% in the last three months. While that is still above the Fed’s 2% target, the Fed has suggested they may be willing to stop hiking rates around that level. The Fed’s policy committee members released a set of their own projections in December. For calendar 2023, they projected core inflation would be 3.5%. This same set of projections suggests most members want to stop rate hikes sometime in the first half of 2023.

These projections give us clues about how the Fed might react to a given economic outcome. Specifically, they are saying that if core inflation were running about 3.5%, they would be willing to stop hiking rates. But, as we said, inflation is already running at about 3.1%. So the Fed may want to see a couple more months of softer prices to feel confident in this trend. That would make March the right time for the Fed to stop hiking rates.

What does that mean for markets?

Both stock and bond prices have risen so far in 2023, largely on optimism about inflation and the Fed. Clarity around the Fed’s rate hiking path removes a significant source of uncertainty for investors, which forms a good foundation for a healthier market in 2023.

In 2023 we think markets will be less focused on the Fed and interest rates and more on company profits. All this slowing of spending is good for inflation but could hurt company revenues. Markets will need to ascertain how much this slowdown will impact company profits. If the slowdown is mild and/or companies find a way to continue delivering strong results, we think all the ingredients are there for a strong 2023 for markets.

_Sources:

_{^1. From Personal Income and Outlays report. As of publication the December figure had not yet been released. For the October-December period, an estimate of the December figure was used from the Bloomberg Economist Forecast Survey.}

_{^2.Total weekly earnings is estimated by multiplying total employment by average weekly wages.}