December CPI report shows core inflation cooling, here's what it means for the Fed

Consumer Price Index (CPI) Report Analysis - January 2024

Key Concepts:

• CPI (Consumer Price Index): A measure of the average change over time in the prices paid by urban consumers for a basket of consumer goods and services.
• Core CPI: CPI excluding volatile food and energy prices, providing a clearer picture of underlying inflation trends.
• Year-over-Year (YoY): Comparing current data to the same period in the previous year.
• Month-over-Month (MoM): Comparing current data to the previous month.
• Shelter Component: A significant component of the CPI, representing housing costs (rent and owners’ equivalent rent).
• Disinflation: A decrease in the rate of inflation.
• Federal Reserve (The Fed): The central banking system of the United States, responsible for monetary policy.
• Easing Bias: A tendency towards lowering interest rates.
• Owner’s Equivalent Rent (OER): The implicit rent homeowners would pay if they were renting their homes.
• Yield Curve: A graphical representation of the yields of bonds with different maturities.

I. CPI Report Overview & Initial Reaction

The Consumer Price Index (CPI) rose 3/10ths of 1% month-over-month, aligning with average economist estimates. However, stripping out volatile food and energy costs, the core CPI increased by 0.2%, below the estimated 0.3%. Year-over-year, the CPI rose 2.7%, while core CPI rose 2.6%, matching the prior month and exceeding estimates by a tenth of a percent. This report is viewed as more credible than the previous one, which was questioned due to the government shutdown and methodological tweaks. The consensus is that the data confirms a slowdown in the inflationary picture.

II. Component Breakdown & Key Drivers

The shelter component was a significant driver, increasing 0.4% in December and representing the largest monthly contribution to the overall CPI. The food index rose 0.7% (including both at-home and away-from-home food), and the energy index increased 0.3%. However, the core CPI excludes these volatile components. The Bureau of Labor Statistics (BLS) identified shelter as the largest factor in the monthly changes.

III. Expert Panel Discussion – Disinflationary Trend Confirmation

A panel of economists – Jennifer Lee (Beimo Capital Markets), Claudia Sam (News Centry Advisors), and George Borie (Allspring Global Investments) – discussed the report.

• Jennifer Lee: Confirmed the disinflationary trend, noting the report doesn’t hinder potential rate cuts by the Federal Reserve. However, she highlighted that food prices remain relatively high, impacting consumers directly (currently up 7/10ths of a percent).
• Claudia Sam: Focused on the shelter component, noting that while disinflation is present, it isn’t dramatically driving down overall inflation. She referenced commentary from Fed officials like Steven Meyer, who are looking for more significant shelter disinflation. Owner’s equivalent rent showed a slower pace of increase (3/10ths of a percent) but not a substantial drop.
• George Borie: Agreed with the disinflationary trend, acknowledging a potential “air pocket” at the end of last year. He stated the bond market reacted positively, with bond prices increasing, keeping the door open for the Fed to maintain an easing bias. He emphasized there’s no immediate urgency for the Fed to move, despite pressure from the President. He noted the yield curve is becoming more normal, suggesting the market anticipates potential rate cuts.

IV. Upside Risks to Inflation & Data Concerns

The panel discussed potential risks to the disinflationary trend:

• Stimulus from Tax Bill: Claudia Sam pointed out that the upcoming stimulus could support demand and potentially allow businesses to pass on costs to consumers.
• Tariffs: Businesses have largely absorbed tariff costs thus far, but this may not continue indefinitely.
• Data Distortions: Claudia Sam expressed skepticism about the “cleanliness” of the year-over-year data, suggesting lingering distortions from measurement issues.
• Geopolitical Factors: Jennifer Lee highlighted potential inflationary pressures from climate-related events impacting food prices (e.g., high rice prices in Japan, record oil prices in Spain) and demographic shifts affecting the labor supply.
• Corporate Pricing: Jennifer Lee noted rumblings from corporations about potential price increases.

V. Shelter Component – Deeper Dive & Alternative Measures

The shelter component was a central focus. Jeremy Schwarz (WisdomTree) highlighted issues with the BLS shelter calculation, suggesting it overstates current inflation. He presented alternative measures (Apartment List and Zillow) indicating a negative or significantly lower shelter inflation rate (0.5% vs. the BLS’s 3.2%). He suggested substituting these measures into the CPI calculation would yield a core CPI of 1.6% and a headline CPI of 1.85%.

VI. Federal Reserve Policy & Political Pressure

The discussion touched on the Federal Reserve’s policy outlook and increasing political pressure.

• Fed’s Stance: Jennifer Shawnberger (Federal Reserve Correspondent) reported that New York Fed President John Williams expects inflation to fall in the second half of the year and believes the Fed is well-positioned to support the labor market.
• Political Interference: Jamie Dimon (JP Morgan CEO) and Robin Vince (BNY Mellon CEO) publicly defended the Fed’s independence, responding to pressure from the administration.
• Powell’s Tenure: Claudia Sam expressed concern about the long-term implications of the pressure campaign on the Fed, particularly as Jerome Powell’s tenure as chair nears its end.

VII. Investment Strategy Implications

• Rotation to Small Caps: Jeremy Schwarz suggested a potential rotation from large-cap stocks to small-cap stocks as AI benefits broaden.
• International Exposure: He advocated for increased international exposure, particularly to Japan, citing attractive valuations and potential for growth. He highlighted the Takayichi trades and the WisdomTree Japan Opportunities Fund (OPJ).
• Currency Hedging: Jeremy Schwarz emphasized the importance of thoughtful currency hedging when investing in international markets.
• Defense Tech: He identified the “defense tech super cycle” as a key investment theme, driven by increased spending in Europe and Asia.

VIII. Notable Quotes

• Jamie Dimon (JP Morgan CEO): “I do have enormous respect for Jay Powell. Everyone we know believes in Fed independence. Anything that chips away at that is probably not a great idea.”
• George Borie (Allspring Global Investments): “We don’t need to be worried about accelerating inflation at this point.”
• Jennifer Lee (Beimo Capital Markets): “Food…again at a glance looks like it was still up 7/10 of a percent which is still fairly high and this is what consumers are looking at.”

Conclusion:

The January CPI report suggests a continued slowdown in inflation, particularly in the core CPI. While upside risks remain, the data supports the Federal Reserve’s potential for future rate cuts. The shelter component remains a key area to watch, with alternative measures suggesting a potentially lower inflation rate than the official BLS figures. The increasing political pressure on the Fed raises concerns about its long-term independence, but the market currently appears to be pricing in a continuation of the current policy path. Investors are considering shifts in strategy towards small-cap stocks, international markets (particularly Japan), and the defense tech sector.