Inflation Release Adds to Good News for the Fed…and Bonds
Recent data is moving in the Fed’s desired direction.
The December Consumer Price Index (CPI) numbers are the latest in a string of encouraging data that show a meaningful cooldown in price pressures in the economy. These developments support our view that the Federal Reserve (Fed) will be able to step down the size of rate increases to 25 basis points at the Feb. 1 FOMC meeting and wind down its hiking cycle by the second quarter. This better inflation and Fed environment suggests that the most worrisome scenarios for credit markets are dissipating and gives a positive sign for those looking to invest in fixed income, particularly high-grade credit.
Falling energy prices drove headline CPI deflation on a month-over-month basis but, more importantly for the medium-term outlook, core CPI has now slowed to an annualized pace of 3.1 percent over the last three months, down from 7.9 percent in the three months through June.
The Fed has discussed three distinct components of core inflation, and all three showed promising developments. Core goods prices fell outright for the third month in a row, helped by another big drop in used car prices. With an array of data and surveys suggesting supply chains have dramatically improved and demand for goods is cooling, we expect more deflation in this category in the coming months.
Goods Are Now in Deflation and Services Are Cooling Off
Contribution to 3-Month Annualized Change in Core CPI
Source: Guggenheim Investments, Bloomberg. Data as of 12.31.2022.
If there was any surprise in the CPI numbers it was the persistence of shelter inflation, with rent of shelter inflation showing some month-over-month reacceleration. This strength in shelter is set to fade over the course of 2023, however, as the rental market has softened quite a bit due to decreased household formation, slowing income growth, and looming supply increases. Recent work by the Cleveland Fed using Bureau of Labor Statistics data shows that rent growth for new tenants has fallen quickly in recent quarters, which will begin to show up in the official CPI numbers over the coming year.
Leading Measures Show Rent Inflation Poised to Come Down
Source: Guggenheim Investments, Cleveland Fed, Bloomberg. Data as of 12.31.2022 for CPI, 09.30.2022 for New Tenants Rent with Guggenheim estimate for Q4.
This coming disinflation in rents is well known to the Fed, which is why they’ve shifted their focus to “core services other than housing.” As the first chart above shows, this category has also slowed, with three-month annualized gains of just 1.2 percent. Part of that is due to technical quirks related to health insurance measurements, which the Fed will probably look through as not indicative of underlying inflation. But there’s good reason to be optimistic about services excluding housing, namely developments in wage growth, the major input cost for this component of consumer prices. Last Friday’s employment report showed major downward revisions to recent wage growth figures, and the trajectory now looks much more benign.
Better Wage Growth Picture Bodes Well for Service Sector Inflation
Composition Adjusted* Average Hourly Earnings, 3-Month Annualized % Change
Source: Guggenheim Investments, Bloomberg. Data as of 12.31.2022. *Wages Adjusted for Composition Changes in Industry and Worker Type.
In conclusion, moderating inflation, along with last week’s data that showed labor market pressures subsiding, should give the Fed more confidence the data are moving in their direction and that the need for substantial further tightening is reduced.
By the Macroeconomic and Investment Research Group
- Anne B. Walsh, JD, CFA , Chief Investment Officer, Fixed Income
- Brian Smedley, Chief Economist and Head of Macroeconomic and Investment Research
- Matt Bush, CFA, CBE, U.S. Economist, Macroeconomic and Investment Research
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