QQQ - December CPI Report Preview - Enjoy Disinflation While It Lasts

2024-01-09 08:50:22 ET

Summary

• Consensus expectations for December CPI show a decrease in core CPI inflation from 4% to 3.8%.
• Disinflationary process likely to continue until June due to base effects and decreasing shelter inflation.
• The Fed acknowledges predictable disinflation in housing services, but anticipates the need for weaker demand to further reduce inflation.

December CPI consensus expectations

The US Bureau of Labor is set to release the CPI report for December on January 11th. The consensus market expectations are that the core CPI inflation will decrease from 4% in November to 3.8% in December, with the monthly core CPI at 0.3%; the same as in November. The headline CPI is expected to increase from 3.2% to 3.1%, with the monthly increase of 0.2%, which is higher than the 0.1% increase in November.

Thus, based on the expected month-over-month inflation numbers, it looks like the disinflationary is temporarily stalling.

Disinflation to continue until June

However, the annual core CPI is expected to continue to keep falling, and this disinflationary process is likely to continue at least until June. There are two major reasons why the disinflationary process is likely to continue until June:

First , there are the base effects. The chart below shows the monthly core CPI readings over the last 12 months. The inflationary shock was persistent from December 2022 to May 2023, when the monthly inflation consistently increased by 0.4%, and that was consistent with 5% annual core CPI inflation.

The disinflationary process started in June and July, with a sharp fall in the monthly inflation readings to 0.16% - and that's consistent with a 2% annual inflation. However, subsequently, core CPI settled in the 0.2-0.3% monthly inflation range in the following months, and that's consistent with a 3% annual inflation. Thus, the annual core CPI will likely keep falling until June, as the "old" monthly inflation readings are replaced with the "new" inflation readings, with core CPI falling from 4% to 3% mid 2024.

The second factor that's predictably driving the disinflationary process is shelter inflation. Shelter is about a third of overall CPI, and it was one of the key factors causing the post-pandemic inflationary shock. The chart below shows the annual rent inflation - it's decelerating, but it's still 6.5% higher than in the year-ago period.

However, we know that the rent inflation does not measure the real-time rents reflected in the new rental contracts, it measures the inflation in the existing rental contracts. The new tenant rent inflation in this case is the leading indicator of the "official" rent inflation, and the new tenant rent inflation is already in the pre-pandemic range of 2-3%, with the pandemic inflationary shock well behind, as the chart below shows. Thus, we know that shelter inflation will be falling towards 2-3% over the next 6 months - this is predictable.

However, note that the New Tenant Rent Index is estimated. Here is the methodology by the U.S. Bureau of Labor Statistics :

"The New Tenant Rent Index is a research series that uses rent data from the housing survey used in the Consumer Price Index (CPI). The New Tenant Rent Index measures prices new renters would face if they changed housing unit every period. The rent component of the CPI measures the change in all rents, including new leases, renewals, and rents in the middle of a lease. In contrast, the New Tenant Rent Index uses only a subset of the data the CPI uses, namely the first survey observations after new renters move into their units."

Therefore, the disinflationary process is predictable, at least until June. The shelter disinflation is predictable, while the base effects guarantee that annual core CPI will continue to decelerate, as long as the forthcoming monthly inflation readings are below 0.4%.

What does the Fed say about disinflation?

The FOMC is also confident that the disinflationary process is likely to continue, based on the December FOMC meeting minutes. Specifically,

They observed that progress had been uneven across components, with energy and core goods prices falling or changing little recently, but core services prices still increasing at an elevated pace.

Several participants observed that the ongoing rebalancing of labor supply and demand would help reduce core services inflation.

Several participants assessed that housing services inflation would fall further over time as the earlier deceleration in rents on new leases continued to pass through to broader rent measures.

They assessed that the contribution of improved supply had come from supply chain normalization, boosts to labor supply due to a higher labor force participation rate and immigration, better productivity growth, or increased domestic oil production.

They also noted that restrictive monetary policy had helped restrain growth of demand, particularly in interest-sensitive sectors such as business fixed investment, housing, and autos and other durable goods.

Several participants assessed that healing in supply chains and labor supply was largely complete, and therefore that continued progress in reducing inflation may need to come mainly from further softening in product and labor demand, with restrictive monetary policy continuing to play a central role.

A few others saw potential for further improvements in supply.

Thus, the Fed also acknowledges the predicable disinflation in the housing services inflation. The Fed sees the recent inflationary shock as mostly supply-driven, and the supply-side issues have been mostly resolved, with some further improvement possible. The notes state that the next stage of disinflation might have to come from the weaker demand, for products and labor.

Implications

The monthly core CPI has to return to the 0.1-0.2% range for the 2% annual inflation target to be reached. At this point, it appears that the monthly core CPI is in the 0.2-0.3% range, which is sufficient to bring the annual inflation from 4% to 3% by June, due to the base effects. What happens after June?

The "last mile" inflation fight, or the drop from 3% to 2%, will start in June, and might require softening of demand, based on the Fed statement. That means the economy could start to weaken in the second half of 2024, with a possible recession - as the lagged effects of prior hikes start hitting the economy.

The Fed is likely to start cutting interest rates in the first half of 2024, possibly in March or May, anticipating a slowdown in the second half of 2024. The Fed wants to limit the increase in the unemployment rate to 4.1% and avoid a recession. Thus, the Fed cuts must be aggressive, as the market currently expects. The Fed seems to be confident that a recession is not required to bring inflation to the 2% target, only a slowdown - that's the soft-landing thesis.

Thus, my outlook for the S&P 500 ( SP500 ) is positive for the first part of 2024. The economy is likely to be still growing, while the disinflationary process is likely to continue, and, most importantly, the Fed is likely to start cutting interest rates.

The second half of 2024 will be more challenging, as further disinflation might signal a significant slowdown, if not a recession.

Longer term, we are facing a stagflationary environment due to the unfolding process of deglobalization, and the risk to the outlook is the spike in oil price due to geopolitical escalations, or other types of supply chain disruption.

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