February 14, 2018— The January inflation report surprised to the upside this morning, with the Core Consumer Price Index (CPI), the most widely used measure of inflation, coming in at 0.3% month-over-month (m/m) compared to the consensus expectation of 0.2% m/m. On an unrounded basis it was 0.349% m/m, just shy of being rounded up to +0.4% m/m. The initial market reaction was swift, pushing 10-year Treasury yields higher, bolstering the U.S. dollar, and weighing on S&P 500 futures on expectations of a faster pace of Fed rate hikes. The strong print on CPI supports our expectation of higher inflation this year, but in our view does not portend runaway inflation, nor does it change our expectation of three rate hikes from the Fed this year.
The details were indeed strong. Core CPI is now running at 2.9% on 3-month annualized basis, approaching the August 2011 cycle high (see chart), and the highest during the course of the recovery on a 6-month annualized basis, at 2.6%. The report showed continued robust gains in a number of categories, with rises in shelter, medical care services, and used cars and trucks. Motor vehicle insurance and transportation services showed a particularly large jump, continuing recent gains, while apparel prices spiked after months of declines.
On a year-over-year basis inflation remained tame, mostly due to a sharp, one-off decline driven by cell phone prices in March of last year. That impact will continue to weigh on the 12-month calculation until it rolls out of the calculation two months from now. In this report, year-over-year inflation was unchanged from last month, with headline CPI +2.1% y/y, and core CPI +1.8% y/y. When the cell phone impact rolls out two months from now, year-over-year core inflation is set to jump meaningfully, by nearly half a percent, confirming what this morning’s report suggests, that inflation is very much back at the Fed’s target.
Core Consumer Price Index (excluding food and energy, 3-month annualized %)
Data as of February 14, 2018
Source: Bloomberg, WTIA
Markets will likely react to the data. We have had a higher than consensus inflation outlook for some time (2.6% for 2018), which means that we are not surprised by readings like today’s showing higher core inflation, as well as higher headline inflation (boosted by the recent rise in oil prices). Gains in inflation readings today are likely to give back somewhat in next month’s report, but nonetheless this report supports our view that the macroeconomic environment of steady growth and low unemployment will push inflation higher this year.
As we wrote on January 30, we expect three rate hikes this year. This morning’s report does not change the Fed’s outlook in our view, or change their rate hike path, as it supports their expectations for higher inflation. Recall that the Fed held on to this expectation through 2017, despite months of soft inflation prints, with many in markets criticizing them for relying on a Phillips curve construct (a model which suggests that low rates of unemployment are correlated with higher inflation). This report might be a bit of vindication for them. We believe this inflation report supports their outlook and reinforces the expectation of three rate hikes in 2018. If inflation data continues to surprise to the upside and accelerates, however, that will force them, and us, to reevaluate.
Today’s inflation report confirms a path of stronger inflation we have been expecting, but does not suggest to us that inflation will rise at a pace that will alter our current expectation (and the Fed’s current forecast) for three rate hikes in 2018. We will continue to watch the path of inflation data however, as the risk for inflation remains to the upside, particularly with the tax reform legislation and also the additional budget spending authorized by Congress, both likely to provide additional growth stimulus and possibly add to inflationary pressure. For now however, we continue to expect inflation to remain contained. We also, continue to be neutral on U.S. equities, overweight International Developed Markets and Emerging Market equities, and underweight U.S. fixed income.
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