US Inflation Monitor: Upside Risks Persist Despite Negative CPI Surprise

Summary

• Despite the downside surprise in December’s core CPI, inflation risks are tilted to the upside:
  • Survey based inflation expectations are rising or stable but high.
  • Inflation trends are stable and high.
  • Evidence exists of cost pressures.
  • Domestic demand pressures are pulling up inflation, though this seems offset, so far, by weak worker bargaining power.
  • With a tight labour market and a populist incoming administration, workers could gain market power and obtain higher wages that would lift inflation.

Market Implications

• I expect the Fed to remain on hold in 2025, against markets pricing about 1.5 cut.

Introducing the Inflation Monitor

Welcome to the first edition of my inflation monitor that provides a comprehensive, in-depth assessment of inflation drivers and prospects. I will update it after the CPI and include several other inflation data. Comments are welcomed!

My main conclusions are that data and my macro framework indicate upside risks.

December’s Core CPI Downside Surprise

CPI was in line and core CPI came in below consensus and Sam’s model (Table 1).

Core inflation slowed mainly due to a decrease in goods inflation. Core services inflation was roughly unchanged as a pickup in Owners’ Equivalent Rent (OER) offset slower supercore services inflation (Table 2).

Nowcast and Breakevens (BEs) Down, Expectations Surveys Up

• Following yesterday’s CPI release, the Cleveland Fed nowcast for December core PCE fell to 19bp (Chart 1).
• By contrast, two-year BEs are unchanged on the day and remain at four-month highs at 2.8%, but 5yr5yr BEs fell 4bp and remain in a 2.1-2.4% range (Chart 2).
• Consensus inflation forecasts for 2025, 12m/12m, have been increasing through Q4 2024 (Chart 3).
• On balance, survey based expectations are rising or stable but high:
  • Short-term consumer inflation expectations are stabilizing above pre-pandemic levels while long-term expectations are rising (Chart 4).
  • Firms short-term and long-term inflation expectations as well as the Fed index of Common Inflation Expectations (a mix of survey and market-based measures) have stabilized above pre-pandemic levels (Chart 5).
  • Even FOMC concerns over inflation risks have been rising (Chart 6).

Inflation Trends Stable or Rising

• Core CPI has stabilized above pre-pandemic (Chart 7; since PCE closely tracks CPI, I focus my analysis on CPI, which has a bigger market impact than PCE, see our Event Monitor). Goods price deflation is not large enough to offset still high services inflation. Also, goods price deflation ending could reflect long-term structural factors such as deglobalization, climate change, or higher semiconductor prices (Chart 8).
• Besides core CPI, according to the St Louis Fed, the components that best predict future headline CPI are food, shelter and health care. Two of these are rising (charts 9, 10 and 11). While shelter inflation is falling, it nears market rent inflation, which could become a floor.
• CPI indices that exclude the more volatile price components are mixed: sticky price and median price inflation is still falling but trimmed mean has stabilized (Chart 13).

Evidence of Cost Pressures

• Import prices, that have been leading the CPI, are rising (Chart 13). Unit labour costs have stabilized and remain higher than pre-crisis (Chart 14).
• Fed speakers have recently noted that market-based PCE has been increasing more slowly than inputed price PCE and expect the latter to slow down to the former (Charts 15 and 16). While the gap between market and non-market core PCE is wide, it could close through an acceleration in market-based PCE.

Macro Drivers Signal Upside Risks

• The worsening external trade balance indicates excess domestic investment over domestic savings (i.e., demand pressures and demand-pulled inflation, Chart 17).
• The SF Fed decomposition of core PCE between demand and supply factors shows stronger demand factors than before the pandemic (Chart 18).
• These demand pressures are mitigated by weak workers bargaining power, which two Fed economists argue makes for a flat Phillips curve. Real wages are growing more slowly than productivity and strike frequency is falling (Charts 19 and 20).
• Yet this could change as the labour market is tight and part of the incoming administration’s economic program is partly populist.

Market Consequences

I still expect no 2025 cuts. Following the CPI release, markets priced 1.4 cuts from previously about one.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)