Inflation update: Are consumer prices easing too slowly for central banks?

Executive summary:

  • U.S. headline inflation cools slightly in January
  • UK price pressures slow, but labor market remains robust
  • ECB could continue with aggressive rate hikes this year

On the latest edition of Market Week in Review, Director of Investment Strategies, Shailesh Kshatriya, and Research Analyst Laura Bardewyck discussed recent inflation data from the U.S. and Europe, as well as how these latest numbers could impact central-bank monetary policies.

U.S. inflation decelerates, but not at a fast-enough pace for the Fed

Bardewyck and Kshatriya opened the conversation with a look at the U.S. consumer price index (CPI) report from January, released Feb. 14 by the Labor Department. The report was a mix of good news and bad news, Kshatriya remarked, with the latest numbers showing that inflation continues to decelerate—but not as fast enough as the U.S. Federal Reserve (Fed) would probably prefer.

Digging into the data more, Kshatriya explained that the annual U.S. headline inflation rate declined to 6.4% last month—down a tick from 6.5% in December. In addition, core inflation—which strips out prices from the more-volatile food and energy sectors—inched downward in January to 5.6%, versus December’s reading of 5.7%, he said. “Clearly, there’s been incremental progress in the fight against inflation,” Kshatriya remarked, adding that what drove down U.S. inflation last month was a decline in durable goods prices. However, he noted that core services inflation—excluding shelter, transportation and medical prices—continued to increase in January, climbing by 0.6% on a month-over-month-basis. This is an important development, Kshatriya said, because the Fed cares more about price pressures in this specific category.

In addition to the CPI report, retail sales and producer-price numbers from January were also released the week of Feb. 13, he noted. Both numbers topped analyst estimates, Kshatriya said, with January retail sales surging 3% on a month-over-month basis while the producer price index rose by 0.7%.

The stronger-than-anticipated readings, combined with January’s stunningly strong employment report, has led to some recent volatility in equity markets, he noted, with notable moves in bond markets as well. “Since the January payrolls report was released on Feb. 3, the yield on the 10-year U.S. Treasury note is up about 40 basis points (bps), while the yield on the 2-year note is up by an even-greater 55 bps,” Kshatriya stated.

He explained that the larger increase in the 2-year yield is reflective of the market’s more hawkish interpretation of the data and of recent commentary by Fed leaders. “Fed members have been expressing an upside risk to the terminal federal funds rate they projected in their December dot-plots—and this is clearly influencing bond markets,” he stated, noting that traders are pricing in two additional 25-bps rate hikes this spring.

Labor market remains tight in UK and Eurozone

Turning to Europe, Kshatriya said that in the UK, inflation eased by more than expected in January, falling to 10.1% on a year-over-year basis—down from a reading of 10.5% in December. Core inflation also slowed, he said, declining from 6.3% in December to 5.8% in January. On the other hand, UK labor-market data from the fourth quarter of 2022 came in strong, he said, with an above-consensus 74,000 jobs added and a 6.7% increase in average weekly earnings. In addition, the nation’s unemployment rate held steady at 3.7%, Kshatriya remarked.

This labor-market strength may have implications for future Bank of England (BoE) rate hikes, he noted, explaining that the UK central bank indicated a few weeks ago it might be getting close to the end of its rate-hiking campaign. “With inflation falling but still elevated and wage growth firm, markets are now pricing in a 25-bps rate increase at the BoE’s next policy meeting,” Kshatriya stated.

The eurozone labor market also remains tight, he said, noting that the number of employed individuals rose by 0.4% in the fourth quarter of 2022—doubling expectations for a 0.2% gain. The European economy has generally fared better than feared over the past few months, Kshatriya explained, due to a milder-than-expected winter that has led to lower energy prices. He added that the European Central Bank (ECB) still appears on track to continue raising rates in 2023 to tame inflation, with one official recently remarking that borrowing costs could rise by 100 basis points—or to a level of 3.5%—this year.

“Ultimately, the key theme across the U.S., UK and Europe is that while inflation is moderating, it’s not moderating at a fast-enough pace for central banks. And with economic data proving to be more resilient than anticipated, the implication here is that central banks may have a bit more work to do to bring inflation back down to its target range,” Kshatriya concluded.

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