Here is the latest inflation data and some thoughts on what this means and what could come next.

Following the December 13th CPI report, the Federal Reserve announced its latest interest rate hike and economic projections the next day.

As was widely expected, the Fed raised the target range for the Fed Funds Rate by 50 b.p. to 4.25%–4.50%. In addition, the committee laid out a policy path including another 75-100 b.p. of hikes followed by an extended period of elevated rates and a gradual easing cycle that doesn’t begin until 2024. Overall, the hike, the projections, and the commentary during Chair Powell’s press conference were at the hawkish end of expectations. Notably, the recent “softish” inflation data has not changed the Fed’s view of the world.

Regarding that inflation data, the US CPI for November was softer than expected, with the core index (which excludes food and energy costs) up 0.2% MoM (6.0% YoY). Notably, the core figure was 0.1% lower than the Street expected. This was the second consecutive month of lower inflation and it will feed into the narrative that the Fed has more or less done what it needs to do in order to get inflation under control. 

The details of the CPI report show a split in the economy. Goods prices have declined outright for the last three months, bringing the YoY run rate for goods prices back toward the Fed’s target. Categories like autos, which were significant contributors to the run-up in inflation are now pulling it lower, clearly reflecting significant healing in global supply chains. Transportation, too, is moving lower alongside more subdued gasoline prices, which are now basically unchanged over the last year. That suggests that we should expect transportation inflation to continue to fall.

The details of the CPI report show a split in the economy. Goods prices have declined outright for the last three months, bringing the YoY run rate for goods prices back toward the Fed’s target. Categories like autos, which were significant contributors to the run-up in inflation are now pulling it lower, clearly reflecting significant healing in global supply chains. Transportation, too, is moving lower alongside more subdued gasoline prices, which are now basically unchanged over the last year. That suggests that we should expect transportation inflation to continue to fall.

With goods prices easing, the pressure on inflation is coming almost entirely from services. Shelter, in particular, remains robust, with housing alone contributing more than 2.5 percentage points to CPI. With house prices moving lower, we should expect shelter inflation to fall as well, though it is likely to be several more months before we see true relief on that front.

We continue to believe that a terminal rate of 4.50%–5.00% is appropriate, slightly lower than the Fed’s dot plot. That expectation is subject to the condition that financial conditions tighten back toward where they were a few weeks ago. If they do not—if equity prices keep going up and bond yields stay low and the dollar continues to weaken and spreads compress—the Fed will likely have to go further. The policy rate alone doesn’t have a big impact on the economy; these other prices matter more, and what we have seen in the last few weeks has been a significant easing of financial conditions.

That easing of conditions has occurred largely because the inflation prints that have not changed the Fed’s view have changed the market’s view. There is now a wide gap between the Fed’s expectations and market pricing.  While the Fed expects to raise rates another 75–100 b.p. followed by a prolonged pause above 5%, the market prices both a lower terminal rate and a rapid pivot to rate cuts next year.

How does this resolve itself? The ideal way would be if inflation does in fact come down faster and farther. In that world, the Fed’s expectations would move toward the market’s and disruption would be minimal. That could certainly happen—inflation has started to moderate and nobody, including the Fed, should have high confidence in their ability to forecast inflation many months into the future. The other alternative is that the market is forced eventually to accept that the Fed is in fact willing to stay tight even as growth slows and inflation starts to move lower. We expect it will take some time for that to happen, but if it does, volatility should be expected.