US price pressures ease, although the Fed will want to see more

There were two ways to read the December inflation report in the US, firstly the massive decrease in commodity prices (the good news), secondly, the monthly increase in the core CPI index (the bad news). The market reaction was initially confused: an initial sharp rise in the dollar before a whipsaw move lower across the G10 FX spectrum. E-mini-S&P 5O0 futures are continuing to move higher, which suggests that the market is focussing on the headline rate of inflation, which is has fallen to its lowest level for more than a year at 6.5%, while the annual rate of core US CPI was 5.7%, down from 6% in November. Investors believe that the inflation threat has narrowed in recent months, and with the declines in the annual CPI figures, it does indeed look like inflation is being chipped away as the Fed continues to raise interest rates.

Half-year inflation in line with Fed’s target rate

However, the devil is always in the detail. Leading up to this report, there were some very encouraging signs on inflation. For example, inflation in the 5 months to November had slowed sharply, showing that it was a year of two halves for US price growth, and the peak was behind us. For example, the core PCE rate for the 5 months to November was 2.5%, within touching distance of the Fed’s 2% target, Thus, the focus on the annual rate of inflation meant that we missed the abrupt shift in prices that took hold after last summer. Core inflation also slowed in the last 5 months; however, it was higher than the headline rate of inflation, rising at a 4.7% rate in the 5-months to November. Core prices are considered sticky for a reason. It seems likely that the festive season helped to increase monthly core price growth in the US. Core CPI rose by 0.3% in December, up from 0.2% in November. However, monthly core price growth has been oscillating between 0.2% and 0.3% in recent months, and while a decline in the core rate of CPI would have given the market more confidence that inflation is moderating, if core prices were given a boost in December because of Christmas, then we could see a reversal in January.

You will see a lot of headlines about the fall in energy prices, so instead we will look more closely at the core price growth for last month, and to do this we will divide core prices into two categories: core goods and core services. In terms of core goods prices, there were further price declines for new cars and used cars and for tobacco, while alcohol prices rose by 0.5% on the month, possibly due to increased drinking over the festive and new year period. Likewise, the price of toys also jumped, which could fall back in January as demand eases.

Super-core inflation, the real metric to watch

Core service prices should be on everyone’s agenda right now, as a series of Fed speakers have mentioned core service prices as an important index that needs to move lower before the Fed can change its stance on interest rates and implement the infamous “pivot”. Overall core service inflation was stronger, rising 0.5% on the month, versus 0.4% in November. But when looking at core service data, some analysts have started to look at “super-core” service inflation, which excludes housing costs. If you exclude shelter costs, which rose 0.8% in December, up 0.2% since November, and rent costs, which rose at 0.8%, the same rate as November, then super core price growth looks more palatable. However, there is a valid reason behind stripping out shelter costs in that they can distort an index, since very few people move on a monthly or even yearly basis.

Why these inflation figures could make the Fed squirm

Super core service inflation was a mixed bag for inflation. For example, while airline fares fell 3.1% on the month, continuing a recent trend of large monthly declines, healthcare services were stronger, rising 0.1% on the month, after a 0.7% decline in November.  Hospital services were also sharply higher, although this could be down to seasonal factors. Transportation services were higher, while motor vehicle repair services and motor insurance were up 1% and 0.6% on the month, lower than November, but higher than the overall rate of core monthly inflation. Overall, the super-core service sector inflation for December rose by 0.6%, compared to -1.6% decline in November. One month of data does not a trend make, but it gives us a reason why Fed speakers are maintaining their hawkish tone, even when headline rates of price growth are falling sharply. Ultimately, the Fed bases its policy decisions on the overall core rate of inflation, but if service price growth remains sticky going forward, the pivot narrative could lose some of its oomph.

Why stocks will remain buoyant

Unsurprisingly, the market narrative that we have passed the peak of inflation and prices are going down looks like it has been maintained, as it ignores the uptick in super core inflation growth. Both 2-year and 10-year US bond yields have fallen on Thursday. Overall, this data is likely to fuel the recent rally in risky assets, however, we will be watching closely for the core PCE report and the US BLS quarterly employment cost index, both will be released at the end of this month and will give us more insight into the direction of price growth and what the Fed might do next.

Tesco and M&S power the FTSE to multi-year highs

Elsewhere, there were some strong retail reports from Tesco and M&S over the festive season. Tesco reported that sales grew 7.2% in the 6 weeks to January 7th, even if shoppers were buying more of the budget ranges. M&S reported a surge in the sales of its premium products, it said that the increase was due to the older age profile of its customers who are more insulated from the cost-of-living pressures. M&S had a cracking Christmas, it reported its best ever day for food sales on 23rd December. However, it wasn’t just strong food sales, which were boosted by inflation, that lifted M&S. It reported sales of fashion and homewares that were up 8.8% in the 3-months to December, and said that its click and collect service allowed it to navigate the pitfalls of the December postal strikes. Partywear sales jumped, and formalwear sales were up 40%. These figures defy fears of a gloomy Christmas for UK retailers, although the actual number of items sold could have fallen, particularly for a retailer such as Tesco. Its executives also said that they don’t believe that UK inflation has peaked yet, however, it had no impact on the performance of the FTSE 100 on Thursday, which rose to its highest level since mid-2019.

Overall, the market is in buoyant mood, although the asset prices including stocks and the dollar initially wobbled on the US inflation figures on the back of the uptick in the monthly rate of core CPI, the US inflation figures have gone down well, they are playing into the peak US inflation narrative, and the “Fed will pivot soon” mantra. This is good for stocks and should keep downward pressure on the dollar.