This long-awaited progress on inflation should allow the Federal Reserve (Fed) to slow the pace of interest rate hikes at the upcoming February meeting.
While higher interest rates are having the desired effect on inflation pressures, this comes with the cost of slower economic growth. We still see a path for a soft economic landing where the economy continues to grow while inflation heads back to the Fed’s long-term target of 2.0%. However, interest-rate hikes act with a significant lag and 2022’s historically rapid pace of higher rates will be felt as we move through 2023. While current indicators are consistent with economic growth, most leading indicators are pointing to further economic slowing in 2023. This has us remaining cautious on stocks and other risk assets.
Inflation Moderation Continues
The Consumer Price Index (CPI) edged down 0.1% month/month in December—its first decline since May 2020—led by lower gasoline prices, which slid 9.4%. On a y/y basis, the CPI moderated to 6.5% from 7.1% in the prior month, and a notable departure from the 9.1% peak in June. It was the lowest inflation rate since October 2021. Core CPI, which excludes volatile food and energy, eased to 5.7% from 6.0% in the prior month, the lowest rate this year.
By far, the biggest driver of core inflation was shelter, which rose 0.8% (7.5% y/y), the biggest monthly gain since May 1985. Rent and owners’ equivalent rent each picked up also by 0.8%, while lodging away from home prices rebounded 1.5%, after pulling back in the month before. While alternative indexes show rents and home prices already declining on a monthly basis, they tend to lead the shelter CPI by 12-18 months. This suggests that shelter CPI should moderate markedly later in 2023.
Core goods inflation continued to moderate, posting 2.1% y/y, the least since March 2021 and a far cry from the peak rate of 12.3% y/y in early 2022. Core CPI ex-shelter eased to 4.4% y/y, the lowest inflation rate since April 2021, mostly driven by lower goods inflation.
This CPI report, along with the bigger-than-expected moderation in average hourly earnings growth in the December Employment Report, clears the path for a 0.25% rate increase at the next Fed meeting.
Consumer Sentiment Improves with Lower Inflation
The University of Michigan Consumer Sentiment Index increased the most in five months in the preliminary January survey. While it was still low compared to history, the index reached its highest level since April 2022, as consumer attitudes continued to recover. The current conditions index jumped the most since December 2013, led by a more favorable assessment of personal finances, amid higher incomes and slowing inflation. Both current conditions and expectations posted their best readings since April 2022. This suggests some improvement in the outlook for consumer spending and economic growth.
Claims Still Consistent with Growth
Initial claims for unemployment insurance edged down 1,000 last week to 205,000, the lowest level since September. Claims continue to hover near their pre-pandemic level, which was close to a multidecade low. It shows that despite reports of layoffs in some sectors, mostly tech, labor demand in aggregate remains strong.
Continuing claims fell 63,000 to 1.634 million, while the insured jobless rate slipped to 1.1%. Similar to initial claims, both of these indicators are close to pre-pandemic levels and remain low by historical comparison. It indicates that workers who lose their jobs find new ones relatively quickly, which is another sign of strong demand and tight labor market conditions.
Small Business Optimism Sinks
The NFIB Small Business Optimism Index fell in December to its second lowest level since January 2013. The index is down 9.2% from a year ago, historically consistent with weak economic activity. It supports the argument that the risk of recession going into 2023 is elevated.
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