The decrease in the headline CPI was worse than the expected unchanged reading for December; the CPI was also unchanged in November. The core rate was 0.1% higher following three consecutive 0.2% increases. On a 12-month rate-of-change basis, the seasonally adjusted headline and core rates are now 0.7% and 2.1% higher, respectively.
The CPI's energy price index fell in December by 2.4%, following a small 1.3% dip in November. If we exclude the effects of energy, the CPI would still have increased 0.1% in December and was 1.9% higher than a year ago. The CPI excluding food prices would have fallen by 0.1% and was 0.7% higher year-over-year. Food and energy combined account for slightly less than 25% of the entire CPI. Among the major core components, the BLS reported that the index for shelter (33% of the CPI), medical care, household furnishings, motor vehicle insurance, education, used cars and trucks, and tobacco, were the main components rising in the month; though these were offset by negative readings for apparel, airline fares, personal care, new vehicles, and communication.
It is also worth noting that the "services less energy services" component of the CPI accounts for 59.1% of the entire index and is still growing by 2.9% annually. This should be an important anchor helping offset any commodity-related decreases in prices.
December's consumer prices were again dragged down by commodities, energy, and food. The core rate at 2.1% is now closer to the Fed's target. Though it officially targets the PCE deflator, which owing to a slightly different weighting to Medicare, for example, as well as weighting methodology, it has tended to come in about 0.7 percentage points lower than the CPI. In theory, the headline rate should start to come back up to the levels of the core rate as energy prices levels out and/or actually start to increase. Medical care prices are also facing stiffer upward pressure this year. So far, however, the continued sharp decline in energy prices suggests that this expected return to normalcy will be pushed a little further back than had been expected. More worrying, however, has been the very sharp decline in inflationary expectations, as measured by breakeven TIPS yield spreads. Investors are sending a clear message to the Fed that they believe policy is already too tight and inflation is unlikely to meet the Fed's target. If these expectations are not countered by the Fed in the coming weeks (through rhetoric, Fed speeches, etc.), the danger is that they become self-fulfilling. The Fed has always told us that it will 'look-through' energy price volatility unless it starts to impact longer-term inflationary expectations, unfortunately this now seems to be happening. Inflation is being held back by the slower growth, the strong dollar, and the deflationary headwinds that are increasingly blowing across from the emerging markets as they enter recession, devalue their currencies, and try to get competitive once again. From the Fed's perspective, unless this changes for the better soon, it will be forced to push back its guidance toward the next expected rate increase.
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Richard de Chazal, CFA is a London-based macroeconomist covering the U.S. economy and financial markets.