Inflation Monitor: Still High, Still Sticky

Summary

• January’s CPI upside surprise did not change my big picture inflation view, stuck at about 1ppt above the Fed’s 2% target.
  • Market and survey-based inflation expectations continued rising in January.
  • Inflation trends remained stable and high.
  • Evidence of cost pressures rose with unit labour costs increasing.
  • Domestic demand pressures are raising inflation, though this seems offset, so far, by weak worker bargaining power.

Market Implications

• I expect the Fed to remain on hold in 2025, against markets pricing about 1.1 cuts.

Core January CPI Upside Surprise

Headline and core CPI were above consensus. Sam’s model predicted a small upside surprise to core (Table 1).

Goods and services drove the inflation acceleration. Used cars and other core goods inflation picked up, Owners’ Equivalent Rent (OER) inflation was stable but supercore inflation jumped, driven by higher transportation, recreation and other personal services inflation (Table 2).

Rising Inflation Expectations

Market-based and survey-based inflation expectations have generally been rising.

• Following yesterday’s CPI release, the Cleveland Fed nowcast for January core PCE jumped to 37bp but that for February was roughly unchanged (Chart 1).
• Two-year Breakevens (BEs) jumped 6bp while 5y5y were unchanged (Chart 2). Since the US election, 2yr BE have increased by about 80bp while 5y5y are roughly unchanged.
• Over the past month, consensus inflation forecasts for 2025, 12m/12m, continued increasing (Chart 3).
• February University of Michigan 1yr inflation expectations jumped likely due to consumer concerns over the impact of tariffs (Chart 4). Long-term inflation expectations rose further.
• By contrast, the Fed’s Index of Common Inflation Expectations and the Cleveland Fed Firms’ Inflation Expectations were stable (Chart 5).
• Even FOMC concerns over inflation risks have been rising (Chart 6).

Inflation Trends Stable or Rising

• January core CPI was consistent with inflation stabilization above target (Chart 7, since PCE tracks CPI closely, I focus on CPI that has a bigger market impact than PCE, see our Event Monitor). Goods price deflation is too little to offset still high services inflation. Also, goods price deflation is ending, which 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. Food inflation kept accelerating in January while medical costs were flat (Charts 9, 10, and 11). While shelter inflation is falling, it is nearing market rent inflation and could be 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, which have been leading the CPI, are rising (Chart 13). Unit labour costs have started rising on the back of slower productivity growth (Chart 14).
• Fed speakers have recently noted market-based PCE has been increasing more slowly than inputed price PCE and they expect the latter to slow 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 Indicate Upside Risks

• Worsening external trade balance signals excess of domestic investment over domestic savings (i.e., demand pressures and demand-pulled inflation, Chart 17). Part of the Q4 external balance weakening though likely reflects inventory buildup in expectation of tariffs.
• The San Francisco Fed decomposition of core PCE between demand and supply factors shows stronger demand factors than before the pandemic (Chart 18).
• Weak workers’ bargaining power mitigate these demand pressures, which two Fed economists argue creates 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 the Trump administration’s economic program is partly populist.

Market Consequences

Overall, January CPI adds to my conviction for no 2025 cuts. In his testimony yesterday to Congress, Chair Jerome Powell stated the print ‘showed the Fed still had work to do.’ Following the CPI release, markets priced 1.1 cuts from about 1.4 previous.

(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.)