Breaking News: December CPI Report Reveals Surprising Trend Despite Overall Consistency

December CPI Report

The December CPI came in slightly hot on Thursday morning. The annual consumer price index rose 3.4% on an annual basis. Economists expected 3.2%. The index increased 0.3% in December compared to an expected monthly increase of 0.2%. The hotter-than-expected number probably reduces the chances for a Fed hike in March.

Overall, the soft landing thesis appears intact. Wall Street Journal Chief Economics Correspondent Nick Timiraos suggested that early “translation” calculations from CPI to PCE, the latter being the Fed’s preferred measure, suggests that PCE will likely come in at a lighter 0.2%. This is an encouraging footnote to a slightly hot report that was mostly in line.

The primary reason for the higher expected reading appears to be sticky shelter costs. Rent of Primary Residence and Owners’ Equivalent Rent were the highest two categories other than Motor Vehicle Maintenance. Below, you can see the breakdown of the December report.

As you can see, Energy is still putting considerable downward pressure on the headline number. Used Cars, which were also a significant component of rising headline CPI during the worst of the recent inflation crisis, have also been coming down.

The report is slightly above expectations but still aligns with the general downward trend we have seen for inflation through 2023. Shelter can take an exceptionally long time to show current housing market conditions and is notorious for a lag.

As you can see below, Shelter has also been the primary area, given its significant weight, keeping the CPI significantly above the Fed’s target. In this report, Shelter accounted for over half of the total increase in inflation. One notable component that contributed to the upside surprise was a dramatic rise in auto insurance.

One of the reasons for the difficulty in measuring Shelter is that in many zip codes, the primary single-family and multi-family housing for rent may be very different price points. Different methodologies can also slow how actual current rents show up in the number.

So, on the Shelter side, I think using more current data to complement the headline number is always essential. If you look at the December data from Redfin, for instance, it shows that rents have dropped the most in three years.

So, this concurrent data paints a more encouraging picture of Shelter’s direction and suggests we could be to the Fed’s target within the year. One of the things benefitting the path of rent is that there was a building boom in recent years and supply has increased significantly. Vacancies have become more challenging to fill.

How Will The Report Affect the FOMC? Takeaways

How the report will affect the Fed’s rate-setting committee decision-making is hard to say. Before the report, a stream of Fed officials had already maintained relatively hawkish rhetoric while acknowledging progress. The Fed pays close attention to the Core numbers to help smooth the effects of more volatile components. The core inflation rate also came in slightly higher on an annual basis. The whole ball game is coming down to Shelter.

Current market expectations imply six cuts in 2023, whereas the Fed’s latest Summary of Economic Projections implies only three cuts. So, the market is getting a little ahead of the Fed for the time being, but it may be the right bet if Shelter collapses quickly. As you can see above, despite a hotter-than-expected report, the implied odds for a rate cut in March are still well above two-thirds.

The US consumer is remaining strong, and while they are taking on a lot of credit, I don’t think this is a bad thing, given how stratified our economy has become regarding wealth distribution. Without the aid of credit, the US consumer wouldn’t be able to have as much economic endurance. The banking system has proven itself resilient, and while tomorrow we will have to worry about who overextended themselves, for the time being, this will be fuel on the fire of a mighty economy that has consistently defied negative expectations.

Here is another major factor that will help the Fed’s hand in the last lap of the inflation rate: China is experiencing deflation. One of the major themes I drove home throughout 2023 was the “De-globalization” narrative that so many bearish commentators were clinging to, shown by data to be much more rhetorical than economic. As I predicted in 2023, the Chinese Communist Party needs to cozy up to the West to maintain the economic growth at the heart of its de-facto social contract. Since the globalized economy remains intact, we will import lower prices from China for many vital goods.

I think it is always essential to put yourself in the Fed’s shoes. At this point, a consensus has come around to the fact that the inflationistas were wrong. The last slog of inflation will probably be more accessible than many expect. Paying too much attention to the first-order implications of Fed speakers can be misleading. It makes sense to keep the rhetoric on alert to ensure expectations don’t get too bullish now that sentiment has shifted to a more rosy demeanor. I agree with distinguished former Fed Economist Claudia Sahm.

I think the last mile is going to be the easiest of this whole inflation cycle. We’re starting to see, in particular, some of the extraordinary pricing power that businesses have had due to Covid disruptions. We have worked through a lot of Covid disruptions, and really, that’s the last one. And as that starts to unwind, and we’re seeing some of it in discussions about the holiday shopping. Well, that gets us to two. And it could get us there pretty quickly. -Claudia Sahm to Sarah Eisen on CNBC (Dec 26, 2023)

You see, the fundamental attribution error can be one of the most deceptive of any bias in markets, in my opinion. The Fed has a bazooka to affect the economy through the Federal Funds rate, but the forces of COVID-19 and the incredibly anomalous effect it had on the economy were far more powerful than even the most powerful economic entity on our planet could contend with.

So, I think the soft landing thesis is intact. The first half may include some tug and pull between a Fed wanting to stay hawkish and a market wanting cuts ASAP, but ultimately, the cuts will come and will allow valuations of multiple high stocks to help buoy what seems to be a young bull market.

Risks and Where I Could Be Wrong

There are many risks to a soft landing coming to fruition. Also, many risks could easily result in inflation unexpectedly reigniting in a way that forces extended restricted policy or even unanticipated hikes. At the same time, the US economy has proven resilient in the post-COVID era; it’s important to remember that war has always been a historic driver of inflation.

There is no realistic prospect of the conflicts in Ukraine or Israel/Palestine improving over the years as things currently stand. Russia and Ukraine remain locked in a bloody stalemate, and the military operation in Gaza is ongoing, and I believe there will likely be disastrous humanitarian consequences in its wake. This means there likely won’t be any immediate relief to the increasing risk of attack or seizure along shipping routes in the Red Sea.

I think this is the primary risk for continued elevated inflation. Of course, anything that causes an unexpected spike in energy prices will be a significant threat to the Fed and US consumers. However, as long as we remain within seasonal trends, there should be continued relief in the inflationary fight from Energy going into the Fed’s March meeting. If the winter in Europe ends up being cold, or Russian attacks on Energy infrastructure increase in success, there could be another spike in Nat Gas, similar to when the war began.

Conclusion

The recent inflation report probably slightly increases the chances that a rate hike will not come as soon as the market expects. This could set up for a disappointment at some time in the first half when the market realizes that the Fed will cut less than the six times currently expected.

While the market can get ahead of itself in anticipating the Fed’s actions, I don’t think this tension undermines the economic strength and earnings strength that has driven the stock market close to all-time highs. I have been a proponent of the soft-landing thesis longer than most of my peers. I agree with Wedbush Analyst Dan Ives that 2024 will be a year in which AI reveals its incredible and ubiquitous economic benefits.

Not only is there a lot of strength in the economy, but the AI revolution will affect corporate earnings in a much more direct way than the technology boom associated with the internet did. This means AI will enable the market to beat earnings expectations and achieve sounder fundamentals than expected. I look forward to discussing this concept in more detail and with particular examples as the year progresses!