Inflation Cools Again in December as Economic Activity Softens

Key Takeaways:

• The Consumer Price Index (CPI) declined 0.1 percent in December, its softest month-over-month reading since May 2020, according to the Bureau of Labor Statistics. On an annual basis, prices were up 6.5 percent, a deceleration of six-tenths compared to November. Gasoline was a major drag, falling 9.4 percent over the month, while new vehicles (-0.1 percent), used cars and trucks (-2.5 percent), and airline fares (-3.1 percent) also contributed to the negative headline print. Food inflation also decelerated, rising 0.3 percent over the month, its slowest price increase since March 2021. Excluding food and energy, core prices rose 0.3 percent in December and were up 5.7 percent over the year, an acceleration of one-tenth and a deceleration of three-tenths compared to November, respectively. Shelter continued to be a major contributor, rising 0.8 percent over the month. Additionally, bucking a trend of general disinflation in core goods, apparel prices increased 0.5 percent, an acceleration of three-tenths.
• The ISM Services Index declined 6.9 points to 49.6 in December, its first time below the expansionary threshold of 50 since 2009 when excluding the initial COVID shock. The business activity index dropped 10 points to 54.7 and the new orders index was down 10.8 points to 45.2. The prices paid index continued a generally downward trend, declining 2.4 points to 67.6, its lowest level since January 2021.
• The National Federation of Independent Business (NFIB) Small Business Optimism Index declined 2.1 points to 89.8 in December, its lowest level since June 2022. On net, negative 51 percent of firms expect the economy to improve and negative 30 percent are reporting higher earnings this quarter, an 8 point drop in both indices. 43 percent of firms are raising prices on net, an 8 point drop, though 44 percent are raising worker compensation, an increase of 4 points. Inflation is still rated as the single most important problem for a plurality of firms at 32 percent.
• Consumer (non-mortgage) credit outstanding rose by $28.0 billion in November, according to the Federal Reserve Board. Revolving credit (largely credit cards) increased by $16.5 billion while nonrevolving credit (largely student and auto loans) increased by $11.5 billion.

Forecast Impact:

Inflation showed further signs of cooling in December, in line with our expectations. While the headline index was helped by a large drop in gasoline prices, which are highly volatile and not necessarily indicative of underlying trends, core goods prices continued their outright deflation as well, falling 0.3 percent over the month, their third consecutive negative month-over-month print. And while shelter inflation continued to put upward pressure on the core services component of CPI, we know that home prices and private rent metrics are already flat to declining and will eventually filter through to the official government data over the upcoming year. This leaves core services ex-shelter, which is associated with nominal wage growth. Though we believe this component is likely to be the stickiest moving forward, price gains in most major service areas look to be slowing on a three-month moving average basis. Based on this, we believe the Fed will likely slow its pace of rate increases at future meetings, and we continue to believe the Federal Funds terminal rate will be around 5 percent.

Inflation is cooling in part due to a slowing economy, which is evident in several indicators this week. Though we believe the magnitude of the decline in the ISM Services Index may have been affected by bad weather and abnormal seasonal adjustments, the direction is still noteworthy and indicates that consumers may be pulling back. NFIB respondents also reported lower earnings, suggesting slowing consumer demand. While consumer credit outstanding continued to grow, it is likely near its limit relative to personal incomes given that the ratio of consumer credit debt to disposable income is just above its 2019 average. Further, though debt servicing costs for consumers overall remain below pre-pandemic levels for now, new debt is likely more expensive due to a higher interest rate environment. On balance, we believe the incoming data is supportive of our call for a modest recession sometime in the first half of 2023.

Nathaniel Drake
Economic and Strategic Research Group
January 13, 2023

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