This note explains why the risks around core CPI are skewed to the upside in the next 2-3 months.
(Preamble: last Friday the bond market reversed entirely the post-CPI reaction. As we mentioned on CPI-day, the data were a “neutral news” for the Fed staff and the FOMC. Importantly, the report did not alter the estimate of the terminal rate using the Fed staff (2021) Taylor rule. Therefore, we think that the Friday action was, indeed, rational)
Our analysis
Core CPI set to be higher in January due to residual seasonality, used cars prices. Figure 1 shows the distribution of core CPI (MoM) across months of the year. The data are seasonally adjusted by the BLS (the mean and standard deviation across months should be the same) but the figure reveals residual seasonality. The main takeaway is that while December is the month with the lowest median, January is the highest. All else equal, the “January effect” is expected to add 4bps to the MoM of core CPI compared to the December report. (As an example of how large the “January effect” can be, the MoM of January 2020 was 14bps higher than December 2019: 25bps vs 11bps).
Figure 1. Core CPI MoM distributions across months of the year
Note: the figure is calculated using data from 2000. The body of the whiskers show the 25th and 75th percentiles. The red lines show the median of the distributions. The yellow dashed horizontal line shows the 0.2% threshold; the only month with a median above the 0.2 threshold is January.
The second factor comes from used cars prices. Figure 2 shows the MoM of CPI used cars and trucks together with the fitted values and forecast of a model we maintain. Our model suggests that the drop in used cars prices is set to moderate in January (-0.8% MoM sa) and be close to zero in February. In other words, while in the last 4 months used cars prices have put downward pressure on core CPI, this effect is expected to be smaller going forward (we expect used cars prices to be partially offset by a drop in new vehicles prices but still, the net effect of the two to push core CPI up, all else equal, by 4-5bps with respect to December).
Figure 2. CPI used cars and trucks (MoM) and model fitted values and forecast
Core import prices higher than expected, set to continue strong. Figure 3 shows the MoM of core import prices (“all imports excluding petroleum”). Last Friday the BLS informed that in December core import prices grew 10.1% MoM (not annualized). The news is significant because it is the first month of growth since April and one of the highest readings since the beginning of the pandemic. With the broad dollar depreciating 2% in November and December, imported inflationary pressures are set to come back. Therefore, unless core services inflation moderates significantly (which seems less likely given the persistency of rents/OER), the risks around core CPI are skewed to the upside in the next 2-3 months. Finally, because the measure of core import prices shown in Figure 3 is the one that (in our experience) the Fed staff uses in its medium-term model, the news on Friday does have some implications for the Fed. We discuss it in the next paragraph.
Figure 3. Import prices (MoM, ar), all imports excluding petroleum
Implications for the Fed staff
Implications for the Fed staff: higher forecast but same message to the FOMC. At the end of this week, we will circulate our usual “Pre-FOMC Meeting Package” but we can preview the results. This round, on net, the incoming data (labor market, core CPI, import prices, and energy prices) have been stronger than expected by the Fed staff (as inferred from the FOMC minutes). The news on core import prices is particularly relevant because it triggered an upward revision to the medium-term forecast of core PCE prices (the upward revision is more cosmetic than substantial (1 tenth) but still, it was determined by one data point only). All told, in our view there are no good reasons for the Fed staff to recalibrate its message. There are some encouraging signs in the near-term but also some upside risks. The medium-term remains unfavorable.