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CPI checks most of Powell’s boxes. What now?


The inflation story took a turn for the better on Thursday when the government reported that the consumer price index fell 0.1% from a month earlier. Federal Reserve policymakers will play down the report’s significance and reiterate their commitment to continue to fight price volatility. But privately they must rejoice.

Consider the situation from the Fed’s vantage point. Less than two months ago, Chairman Jerome Powell laid out his framework for thinking about inflation in a speech at the Brookings Institution. Today, most of his hopes and dreams are already being realized. Supply chains are healing and core commodity prices are cooling while forward-looking gauges of market rents signal shelter inflation is also poised to fall soon.(1) Perhaps most importantly, central bankers have received encouraging evidence regarding core services other than shelter – that all the important wage-driven components of the CPI that Powell feared would be the most difficult to tame.

In fact, after stripping out rents and owner-occupiers, prices for core services have increased at an annual pace of just 2.6% over the past three months. When Powell gave his Brookings speech, annualized three-month inflation in that category was 7.1%. Now it is essentially back to its pre-pandemic average.

Even before Thursday’s report, there was growing evidence that inflationary pressures were ebbing in core non-housing services. A Jan. 6 report from the Institute for Supply Management showed a measure of prices paid by service providers fell for a second month. Meanwhile, increases in average hourly earnings – which Powell has flagged as a leading potential driver of service sector prices – have moderated significantly. While wage growth is running above pre-pandemic norms in both the goods and services sector, the latter has experienced a sharp decline.(2)

Of course, Powell and his colleagues will continue to argue that inflation remains “too high”, but this is something of a rhetorical trick. If traders sniff out lower inflation and the end of rate hikes, markets will rally further so that bond yields and borrowing costs will fall, and – in the Fed’s view – that could revive inflation. In a technical but misleading sense, it is true that the Fed is still missing its 2% inflation target. With the latest report, the change from year to year in the overall consumer price index is 6.5%. That should leave the Fed’s preferred inflation gauge, the personal consumption expenditure deflator, at around 4.7%, according to Bloomberg Economics calculations – well above the 2% target. The Fed will likely raise interest rates by another 50 basis points or so to ensure it gets the job done.

But in a practical sense, the central bank is not actually missing its target by much, and a shift in policy is very much in play towards the end of the year. Changes in the CPI measured year-over-year are strongly subject to base effects, which means that they say as much about where prices were in December 2021 as December 2022. Prices are not going up much right now. Based on the last three months of core CPI data, the annual inflation rate is just 3.1%. With headline inflation, prices are only up 1.8%.

It is clear that there are some flaws in the report – that cooling in the shelter CPI has still not really materialized despite the leading indicators – but there can be no doubt that the overall inflation picture looks bright. Not only that, but it’s the third report in as many months to support that conclusion, meaning it’s probably not a fluke. Bond markets have noted that the yield on the two-year Treasury note fell six basis points to 4.16%, heading for its lowest close since Oct. 5. The S&P 500 fell slightly, understandably, because lower inflation does not rule out a recession and an accompanying drop in earnings. Higher interest rates take some time to bite and often with harsh and unintended consequences.

Another rate hike is certainly possible, like the one that occurred in the late 1970s after Fed Chairman Arthur Burns felt he had beaten inflation in 1976. We cannot rule out the idea that there are larger structural issues at play. here that requires a long-term war against inflation. But using Powell’s own criteria, there can be little doubt that this particular fight is almost over—no matter what the Fed chairman and his colleagues ultimately say publicly.

More from Bloomberg Opinion:

• A soft landing doesn’t mean the economy is safe: Allison Schrager

• Is 2% inflation in sight? Be careful what you wish for: John Authers

• Who is afraid of the big bad interest rate break?: Daniel Moss

(1) Shelter inflation enters the CPI with a well-known lag relative to market rates, but alternative data from providers such as Zillow suggests that shelter inflation should soon slow.

(2) The jobs report from the Bureau of Labor Statistics last week showed that average hourly wages at private sector service-producing firms are increasing at a 4.1% annual pace, based on data from the past three months. The average before the pandemic was about 3.4%. To be sure, the data has been volatile and occasionally misleading lately. Before the latest revisions, the same data series appeared to accelerate in November. A more definitive verdict on the state of wage pressures will come from the BLS’s more reliable Employment Cost Index, which is published quarterly and will next be updated on January 31, the day before the Fed’s next rate decision.

This column does not necessarily reflect the opinion of the editors or Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg journalist in Latin America and the US, covering finance, markets and M&A. Most recently, he has served as the company’s office manager in Miami. He is a CFA charterholder.

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