US Disinflation Is More Fiction Than Fact

Summary

• January Consumer Price Index (CPI) was in line with expectations, though the details show no sign of impending disinflation.
• Core goods inflation turned positive despite continued used vehicle price deflation, which could reflect that the improvement in global supply chains has run its course.
• Housing inflation did not slow, and stabilization of home prices and rents suggest the much hoped for slowdown may not happen.
• Core services inflation did not slow, while unemployment, at a 50-year low, imparted more upside than downside to wages, and therefore, to services inflation.
• A 25 to 50 basis point (bp) increase in the terminal Federal Funds Rate (FFR) in the March Summary of Economic Projections (SEP) appears likely.

Market Implications

• Despite a recent increase in the terminal and December 2023 FFR, the market continues to underprice the Federal Reserve (Fed).

Core Goods Deflation Has Become Inflation

December CPI MoM was in with expectations at 0.5% MoM for headline inflation and 0.4% MoM for core inflation (Table 1). The details, however, show no sign of disinflation.

Despite a continued fall in used vehicles prices, core goods inflation turned positive. 

Used vehicle prices contracted by 1.9% MoM, similar to December’s 2%. Even after a year of decline, used vehicles remain expensive relative to new ones (Chart 1). Given the limited increases in new car prices, used car prices likely have further to fall.

Nevertheless, core goods inflation turned positive because of a 46bp increase in other core goods, compared with a monthly increase of about 20bp through Q4. We may have reached the limit of the improvements in global supply chains, as shown for instance by the New York Fed’s Global Supply Chains Pressure Index moving sideways since September 2022. As a result, goods prices downside could be limited in future.

No Letdown in Housing Inflation

Shelter inflation at 74bp MoM and 7.9% YoY was comparable to December’s 79bp and 7.5% YoY. Because leases typically get set only once a year, the housing CPI typically reflects changes in rents or home prices with a lag.

However, property prices and the Zillow Rental Index have been stabilizing (Chart 3).  Apartment list rental index shows a continued and greater decline than Zillow’s index, but this likely reflects that it covers mostly the multi-family segment of the market, less desirable than single family homes, and where overinvestment could have been greatest (Bilal’s interview of Ivy Zelman). 

If the stabilization in rents and home prices continues, there is a risk the much hoped for slowdown in housing inflation may not happen.

In any event, I remain doubtful that there is much correlation between house prices and rental costs. Since the 1980s shelter costs have become much more correlated with wage growth than with property prices (Chart 4). Simultaneously, the volatility of house prices has increased, which suggests they have become more responsive to credit conditions or investors’ expectations than to economic factors, such as affordability or household income  (Property Prices Will Not Solve the Fed’s Inflation Problem). 

Services Inflation Ex-Shelter Accelerates

Core services ex-shelter inflation was 31bp MoM, roughly in line with November. Medical services decreased by 0.7% MoM, largely due to a decrease in medical insurance costs of 3.5%, that itself reflects accounting conventions (Health Care Costs To Trend Higher). Transportation costs increased by 0.9%, following a 0.6% increase in December. 

Core services inflation ex-shelter remains closely correlated to wages (Chart 6). Though median wage growth has slowed, and core services inflation ex-shelter has stabilized, both remain well above levels consistent with 2% inflation. 

In addition, an unemployment rate that is the lowest in 50-years suggests upside to wage growth and to services inflation (January NFP Review: One for the Hawks)

Core Inflation Responds Little to Lower Energy Prices

Overall, the slowdown in core inflation likely reflects the slowdown in energy inflation. When inflation is high, energy and core inflation become correlated (Chart 7). This likely reflects the higher correlation across price categories typical of a high inflation regime (BIS study: Inflation: a look under the hood). 

Meanwhile, prices have been much more responsive to rising than falling energy prices (Chart 8). This suggests a lack of competition in the goods and services sectors, and margin behavior that could make it difficult for the Fed to bring down inflation without a recession.

Finally, the median price CPI, a better indicator of inflation trends when core goods prices are volatile, confirms the resiliency of inflation (Chart 9).

Market Consequences

In recent days, Federal Open Market Committee (FOMC) members, starting with Fed Chair Jerome Powell, have been hinting at a possible increase in the terminal FFR in the March SEP. A 25 to 50bp increase seems likely, in view of the stronger-than-expected economy and of the easing of financial conditions: Goldman Sachs’ Financial Conditions Index is now back to its level of end-August 2022, when the FFR was 225bp lower than it is currently.

By comparison, the market is pricing a terminal rate at 5.26% in July and a December 2023 FFR at 5.06%. I think the market is still underpricing the Fed.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(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.)