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The markets and the Fed were previously not aligned on coming rate increases. Over the past week, the markets have shifted to the Fed’s view, expecting another hike in March and likely May as well. This may be in part due to January’s strong jobs numbers reducing recession chances, but it could also reflect certain fears around January Consumer Price Index (CPI) data. There’s a chance that it may not be quite as rosy as some hope.
On Valentines Day, February 14 at 8.30am ET we’ll see the CPI report for the month of January 2023.
To be clear, recent inflation data has been generally good. Inflation has trended lower. That’s been due to easing energy and food costs, and the prices for used cars and various goods have actually fallen in absolute terms in recent months.
The Fed has started to acknowledge these encouraging trends too. However, concerns remain, specifically as shelter costs which carry a large weight in the CPI series continue to rise steeply. There’s good reason to think that might change, but we haven’t seen it in CPI data yet. Also, the Fed worries about wage growth continuing to push services costs higher, and the recent strong jobs report won’t have comforted the Fed on that score.
There’s a chance coming inflation data is a little less reassuring. Certain energy prices, such as crude oil, are no longer declining. Food and energy have helped bring down headline inflation numbers in recent reports.
The Federal Reserve Bank of Cleveland produces nowcasts of inflation using currently observable prices. As of February 7, 2023 they project January core CPI at 0.46% month-on-month and February CPI at 0.45%. For the past several months, these nowcasts have overstated inflation measures, and that may happen for early 2023 too. However, if these nowcasts hold, then these readings won’t inspire the Fed that inflation is rapidly moving back to the Fed’s 2% target. That rate of monthly inflation, if sustained for a year, would result in annual inflation of around 7%.
The real wildcard in the CPI report is housing. Redfin data, show house prices have been trending down since May 2022, and are up just 1.4% to December 2022 on an annual basis. That’s a lot lower that the price growth we saw for much of 2022.
However, due to statistical lags, the CPI measure of housing costs, or shelter costs as CPI term it, continues to rise strongly. Assuming shelter costs ease, as many including, Fed Chair Jerome Powell anticipate it will, in coming months, that will make a big change in the CPI readings. That’s because housing costs carry the largest single weighting in the the CPI report.
However, we don’t know exactly when housing will start to moderate in the CPI calculations, assuming things play out as expected. If we see that in the upcoming data, it may offer some reassurance to the Fed and markets, even though the move is broadly expected and it could help headline inflation move lower in 2023.
The Fed’s Reaction
After raising rates 0.25 percentage-points in February, the Fed is firmly expected to make a similar move on March 22. However, the May meeting’s outcome is less certain. After the strong jobs report, the market has shifted to anticipating that the Fed most likely raises rates one final time, but the outcome will likely prove dependent on upcoming economic data such as January’s CPI numbers and upcoming jobs data.
The upcoming CPI reading will be important to the Fed, and markets. The generally accepted narrative is that inflation is trending lower. Still, if CPI data shows prices not moderating as fast as the Fed would like, then that could be further justification for another rate hike in May, which markets view as probable at this point, and there’s even an outside chance of a June hike from the Fed if inflation remains stubbornly higher for longer.