Inflation in focus: Unpacking the latest CPI report

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Mike Hanson: So our outlook for inflation for the rest of this year doesn't really have a material slowing in inflation despite what we've seen in the recent data. We're looking for inflation to pick up to around, if not maybe slightly over, 3% earlier in the year largely due to tariffs. And, by the time we get to the end of the year, we're gonna still be running around 3% or so for inflation as well.

Phoebe White: Welcome to J.P. Morgan's Making Sense. I'm Phoebe White, senior U.S. rates strategist and head of U.S. inflation strategy. And, today, I am joined by senior economist Mike Hanson to discuss takeaways from the January CPI report and where we see inflation going from here. This episode was recorded on Wednesday, February 18th. Mike, thanks so much for joining us.

Mike Hanson: Thanks for having me.

Phoebe White: So, Mike, the January CPI report showed headline CPI inflation up just two-tenths on the month, ticking down to 2.4% over a year ago from 2.7 in December, core CPI, which excludes food and energy, rose three-tenths on the month, bringing the year-ago rate to 2.5%. And both of those readings were softer or more benign than we had expected. What were the biggest takeaways from the report in your mind?

Mike Hanson: Yeah, I think what wasn't surprising is that inflation is cooling, right? So that's something that we know. But, I guess, as you pointed out, it was a bit less, uh, strength in the report than we might have thought we were gonna get otherwise. Um, I think one important feature of past CPI prints around this time of the year is that they tend to be firm at the start of the year when firms tend to reset their prices. We did some prior analysis of that that suggested it was particularly evident in core inflation and particularly in January's and, while there was some evidence of that phenomenon, uh, we didn't get, uh, quite as much of this so-called residual seasonality, uh, as we had expected. We also, uh, are looking for tariff impacts. And we think that those are still evident in the prices for various imported goods, particularly durable goods like furniture and appliances, uh, also consumer electronics. But the pass-through there continues to be gradual, and so that's another thing that I think we've noted there. And then, finally, we were looking for a bit of a spillover effect from the federal government shutdown in October into early November last year that had delayed some data collection. Uh, and we were thinking that would be, uh, of source for some additional catch-up. And we got maybe a little bit less of that than we thought as well.

Phoebe White: So let's just dig into some of the details there. Uh, of course, a large decline in energy prices contributed to the softer headline inflation print. Do you see this downtrend continuing in the coming months?

Mike Hanson: Yeah, it's a good question, because energy prices had picked up a little bit mid-month last year and then uh, had declined, and so, for the year as a whole, energy prices are effectively flat going into January, uh, over the last 12 months. We do expect that there will be some further downward pressure particularly on oil prices. This is a forecast from our commodity strategists. That excess supply will put downward pressure on oil prices over the year. And oil prices tend to, with a bit of a lag, feed through into gasoline prices, and so that should also be a source of some downward pressure. But it's worth reminding that geopolitics adds a lot of volatility to oil prices. We've certainly seen that recently,  and so that does make it a little bit of a wild card. They did jump six and a half percent last month and so that could feed into energy prices, particularly gasoline prices in the near term. Uh, but oil prices are down 16% over the past year from, uh, above $80 a barrel to now in the mid-$60. And our forecast is for that to fall further. So, all else equal, that will likely put some further downward pressure into energy prices. Two other wild cards that we've seen, one is weather, uh, that, obviously, we've had a big cold snap here in, uh, the Eastern half or more of the U.S., and so that has put a bit of upward pressure on residential energy prices of late. And then the other one that's out there that's gotten some attention is the buildout of data centers from the AI boom. And that has put some upward pressure on electricity prices particularly in certain parts of the country. That demand, of course, isn't going away. And it will take time to build new sources of power generation and transmission, but, with all the focus on affordability going into the midterm elections, you could see some policymakers attempt to find ways to mitigate those impacts on consumers.

Phoebe White: Okay. So some impact, you know, in the opposite direction coming from electricity and even gas services prices, but the bigger trend is we see oil prices moving lower, which should weigh on on gasoline. So let's just touch on food quickly as well.

Mike Hanson: Sure.

Phoebe White: We saw a smaller monthly gain in January there, but food prices are up 2.9% over a year ago. Anything notable on that front?

Mike Hanson: Yeah, we did jump seven-tenths in December, and so the two-tenths was, uh, a nice pullback in that regard. And, as you noted, we're running just below 3%, uh, on a year-ago basis for food. But, the way food is collected by the BLS, it's actually broken into two categories. One part is, basically, groceries, what the Bureau of Labor Statistics calls Food at Home. And that's up only a little more than 2%, 2.1% over the last year. Uh, Food Away From Home, that is, dining out and, and the like, that's of about 4%. And so raw food prices, while volatile, have not been as significant of a upward pressure on the overall food prices as dining out which has, of course, an important labor component to it. Um, you have seen some real volatility in food prices over the last year, right? Eggs obviously comes to mind. And egg prices were down 7% further last month. But you did see increases in things like fresh fish, bacon, uh, canned fruits and vegetables, condiments. They were all up three to 5% on the month. Other items such as, uh, steaks, pork chops, oranges, they saw declines in the month. Some of that may be related to some of the tariff relief we got last year, right? So there's some volatility there, but, generally speaking, uh, you're seeing some modest increases in the cost of actual food and some slightly bigger increases in the cost of dining out.

Phoebe White: Okay, a lot of volatility and energy and food.

Mike Hanson: Yes.

Phoebe White: Let's turn to the core basket.

Mike Hanson: Sure.

Phoebe White: And I think we could probably spend an entire podcast-

Mike Hanson: (laughs)

Phoebe White: ... just talking about core goods inflation.

Mike Hanson: Right.

Phoebe White: But let's talk about what we're seeing there. You mentioned, before you've been looking for evidence of tariff pass-through, um, core goods inflation was essentially flat in each of the last two months, but, clearly, a lot of that coming from the decline in used car prices.

Mike Hanson: Right.

Phoebe White: How are you thinking about the trajectory of core goods inflation from here?

Mike Hanson: Just to clarify for those on the line who might be completely familiar with the idea of core inflation, it's not uncommon to strip out the more volatile parts of inflation to try to get a sense for what the underlying trends are. And so this is what the core that is commonly discussed in the context of U.S. inflation, which is excluding food and energy, represents. And it's not because economists or central bankers don't eat and drive, right? It's because these are very volatile, uh, components as we talked about earlier. And if we wanna know where inflation's underlying trends are likely going, we wanna look past those measures. So, as you mentioned, core inflation has taken a bit of a step-down. Uh, we're at two and a half percent at a 12-month basis. Uh, that is the slowest pace since the pandemic-related inflation surge began in 2021. I think it's though a bit premature to declare that we're on our way back to the Federal Reserve's 2% inflation target quickly. However, uh, you did note that core goods was running flat last month, uh, but, over the last year, it's running a little bit more than 1%. And that's unusual because, typically, core goods are flat to even slightly down over the year. And that reflects the benefits of technological advances and core goods and then, of course, the benefits of globalization helping to put down the prices of core goods. As you noted, auto prices, uh, have been a little bit of a puzzle for us of late. Some of the industry data suggested we should have seen larger increases than we've actually gotten in the CPI. If we take vehicle prices out for a minute here and focus on core goods, other than vehicle prices, you're up four-tenths in January. That's a pretty firm number. And you're up more than 2% on a year-ago basis. And that has been accelerating over the last several months. Uh, again, that number is typically negative, and so that... And we'll talk about this probably more in a few minutes, but that seems to be indicative of the idea that tariffs are, are having an impact on core goods prices.

Phoebe White: So, before we move into core services inflation, just a couple of follow-ups there.

Mike Hanson: Mm-hmm.

Phoebe White: Um, you mentioned there's clear evidence that tariffs are having an effect on parts of the goods basket. How much more tariff pass-through do you think is still in the pipeline? I think this is important for our call as we're thinking about-

Mike Hanson: Sure.

Phoebe White: ... inflation over the first half.

Mike Hanson: There's a wide range of estimates on what exactly that is. There was a recent New York Fed study that just came out that said, "More than 90% of the tariff incidence is being felt by American firms and consumers," but the breakdown between consumers and firms is, is somewhat up for question. Our view is that you will likely see inflation firm, uh, additionally this year. We are looking for the core CPI, uh, run rate to move back above 3% for a time. And we're gonna end the year, we think, uh, on a 12-month inflation basis of around 3%. So that would suggest that perhaps still at least half of the pass-through is still yet to come.

Phoebe White: Got it. Okay. And then just one, one more follow-up on thinking about goods prices. Obviously, we've seen the dollar decline over the past year. We saw some bigger moves at the start of this year, and it's gotten some attention. How should we think about sort of moves in the dollar and the pass-through to inflation?

Mike Hanson: So, generally speaking, a weaker dollar means more expensive imports, and then that has the potential to feed through to inflation. What we do note is that, in the case of the U.S., the pass-through is a lot less than in many other countries because a lot of goods are already invoiced in dollars, and, therefore, there's really no scope for the dollar swing to change the invoice prices. It's already in dollars after all, right? But if you kinda look at the historical behavior, you should probably expect that a 10% depreciation of the U.S. dollar on a trade-weighted basis, on a broad basis, which is pretty close to what we're seeing right now over the last year, is somewhere between one to maybe two or maybe a little bit more than two-tenths increase in overall inflation. That said, the data seems to suggest that the speed at which that pass-through has occurred may have slowed post-pandemic, and so it may take longer for that impact to be fully felt. So that is another risk potentially to the upside, against the observation that we've seen a bit of a slowing in inflation more recently.

Phoebe White: That's great. Thanks. So let's move to services now.

Mike Hanson: Sure.

Phoebe White: And I think we'll take this in two parts. Obviously, there's been a lot of attention on rent inflation.

Mike Hanson: Right.

Phoebe White: So the two primary housing components in CPI, primary rent and owner's equivalent rent, or OER-

Mike Hanson: Mm-hmm.

Phoebe White: ... both came in somewhat softer than we expected, though OER, of course, has been choppy in recent months. How much room do you think there is for softening in this component?

Mike Hanson: I do think the trend there is likely lower, right? So you obviously had some really significant surges in rental prices, you know, a few years or so ago now when there was a lot of people moving around, uh, as a result of the pandemic. And that pressure certainly has abated to some extent. You've also seen some pickup in construction particularly in the multifamily space, so for apartments. And that has,  you know, increased in supply, has put some likely downward pressure as well. If we look at what rental indicators have been suggesting, uh, say, market measures, they've been suggesting that rental inflation should be coming down quite dramatically. They've really over-predicted how quickly inflation will fall, and so we've taken that on board to recognize that this is a fairly inertial measure. And it, it will decline, but it'll decline fairly gradually. We also look at where home prices have gone. They tend to lead with a good year or more where rental inflation prices are going. And those are, again, consistent with the idea that we should see rental inflation continue to slow. So a run rate of something that's now at or maybe a little bit above 3% should probably be a bit below 3% as the year goes on.

Phoebe White: And then maybe just to add to what you mentioned on the, market measures of rent inflation, of course, we have seen that big drop there, I think it's important to recognize those market measures, look at asking rents or new leases.

Mike Hanson: Yes.

Phoebe White: Uh, the CPI measure of rent inflation looks at the entire housing stock. And we've seen this divergence between the pace of increases on rent renewals versus asking rents, part of that having to do with high mortgage rates, less churn in the market recently, um, higher retention rates in the rental market. So all of that is I think contributing to that divergence between what we see in the CPI measures versus some of these market measures.

Phoebe White: One other quick point on this front-

Mike Hanson: Mm-hmm.

Phoebe White: ... just because there has been a lot of focus on rent inflation. We know there's some sort of residual distortion in at least these year-ago measures of rent inflation coming from the shutdown.

Mike Hanson: Correct.

Phoebe White: This is a component where the sample is, you know, split into segments that are each repriced only once every six months, so we should get a bigger bump in rent inflation coming in April.

Mike Hanson: Correct.

Phoebe White: So let's move on from rent inflation and talk about the rest of the services' basket core services-

Mike Hanson: Mm-hmm.

Phoebe White: ... ex housing. We've typically argued this is a component that should be most sensitive to labor market conditions, uh, wage pressures. We saw conflicting data last week, right? We saw a step-down in the employment cost index, ECI. Average hourly earnings came in a bit stronger. How are you thinking about how labor markets feed into the picture here?

Mike Hanson: That's a great question. Um, it's obviously not a, a very simple relationship unfortunately. There's a lot of lags and there's a lot of other factors that complicate the relationship. But generally speaking, we have seen the labor market cool through really the back half of last year. And that's most notable in the fact that you've seen an, an upward drift in the unemployment rate. And you've seen payroll growth really slow quite substantially. And so, with a lag, that tends to put downward pressure on wage growth because, as the labor market softens, people's ability to negotiate for higher wages obviously is not as strong. But that said, you know, on a year-ago basis, we are seeing, uh, the two key measures of wage inflation in the US, so one being the employment cost index, which we get quarterly and we just got, and it came in at 3.4% for the year. And then that we have a monthly measure that we get as part of the jobs report, average hourly earnings, which for technical reasons is maybe not quite as good a measure even though it's a more and more frequent measure, that was 2.7% on a year-ago basis. So, if you kinda average between them, we're still running about three and a half percent right now. That pace is likely to show some further slowing, given the weakness we've seen in the labor market to date, but our forecast on a forward basis is for the labor market to bottom out and start actually showing a bit of recovery given just how strong GDP growth has been, the fact that we have had three quarters of a percentage point of reduction in interest rates coming from the Fed, and we have some tax breaks coming on board over the next several months. And so all of that we think will give some support to the labor market, and so I think, when push comes to shove, we shouldn't really expect there to be a significant further disinflation on the, you know, core services ex shelter, the so-called supercore as some folks like to call it. We might get some softness in the near term. But, again, a labor market that's gonna show some signs of recovering over the course of this year is not really a labor market that's gonna put a lot of further downward pressure on that component of the CPI.

Phoebe White: Great, so let's just put all the pieces together. Given everything we've discussed, what is your overall outlook for where core and headline inflation head over the course of the year?

Mike Hanson: Yeah, we're looking for those numbers to, again, on the CPI side, which is important because the Fed looks at a slightly different measure we'll get to in a minute, to continue to run at levels around, if not a bit above, 3% for much of this year. And so we'll likely end the year with inflation not really appreciably lower than when we started the year.

Phoebe White: And one more question just on the CPI side before we turn-

Mike Hanson: Mm-hmm.

Phoebe White: ... to PCE. Uh, obviously, there have been concerns about data quality this year, uh-

Mike Hanson: Right.

Phoebe White: ... questions about how CPI measurement could change under the new BLS leadership. How are we thinking about this topic?

Mike Hanson: Yeah, it's obviously an important question, because if we don't get good data, then it's hard for, for businesses and for policymakers and just for, you know, the average person to really know what the state of the economy is and to make good decisions. What's encouraging to this point is there really is no evidence that there has been any kind of, say, political manipulation of the data, which I think is a concern of some folks. I think there is a broader challenge here though. The BLS is underfunded and understaffed. There has been a significant reduction in staff over the past year as a result of attempts to shrink the footprint of government employment. And I think we're at a point now where there are legitimate questions about whether the quality of the data is as good as it might have been historically. And a key place we're seeing that is that response rates for this survey have come down quite dramatically. Right? And so, if people aren't answering the BLS surveys, it's awfully hard to get accurate measures of the things they're trying to inform us on.

Phoebe White: Okay. So, now, let's turn to PCE.

Mike Hanson: Mm-hmm.

Phoebe White: Clearly, the Fed targets PCE inflation formally. So without getting too technical-

Mike Hanson: Right.

Phoebe White: ... are you expecting a similar trajectory for core PCE inflation, and, and what does this mean for our Fed call?

Mike Hanson: Sure. So, again, for those who may not be fully aware, PCE is the personal consumption expenditure deflator. It's an alternative measure of inflation. It is one that, for some technical reasons, the Fed prefers to look at over CPI. It's viewed as being a bit more accurate. And it tends to move together. Typically, because of the technical differences, PCE often runs slightly below CPI, but, you know, a couple of tenths on a, on a annual basis, not dramatically. And so we are looking for a broadly similar pattern in that. We do think there'll be some upward pressure coming from tariffs, uh, earlier in the year into mid-year. And we do think that we're gonna end the year not appreciably different than where we started the year.

Mike Hanson: So based on information available to us at the time of this recording,  it seems likely that we'll actually see in the near term somewhat a firmer core PCE measures than the core CPI numbers that we've seen. And, again, since that's the number the Fed pays more attention to on the inflation side, that's noteworthy. But, again, over the course of the year, we still think it's likely that we're not gonna get really significant improvement, uh, on the inflation side. And that's a key reason to think that Fed officials are going to be very cautious in what they do going forward.

Phoebe White: And so our Fed call is?

Mike Hanson: Our Fed call, in contrast to the markets, is for the Fed remain on hold this year. And so that is informed by the inflation outlook but it's not driven solely by the inflation outlook. As we mentioned, we do think that the economy will show some rebound particularly in the labor market as we go forward. Uh, we have the unemployment rate coming down by year-end. And that, again, is an environment where Fed officials last year were concerned about possible weakness and downside risks in the labor market. And those will certainly be abated if we see, uh, some of the improvement that we're looking for. But we also are thinking that inflation is gonna be sticky, if you will. That a technical term amongst economists, right, that it's not gonna go down a lot. Fed officials are targeting a 2% inflation. We've been at or above 3%, and certainly at or about 2% now for, uh, six-year running. And that is certainly a challenge for, uh, Fed officials. And a number of Fed officials have been very clear that they really need to see more evidence of inflation coming down before they're likely to cut. And we're just skeptical they're gonna get clear evidence of that this year.

Phoebe White: So you mentioned the difference between our Fed call and what the market is pricing. And I do think a part of that has to do with the differences in how we're viewing inflation versus what the market thinks. If you look at inflation markets at least, it appears the market is incredibly sanguine on inflation risks. You can look at inflation swaps and tips. They imply headline CPI inflation will actually tick lower to 2.3% by the end of this year and basically stay flat at that level in coming years. And you can look at the forward curve. It's incredibly flat near that 2.3, 2.4% level all the way out to 10 years. The Fed's 5-Year, 5-Year inflation expectations measure is sitting right around 2.4. It's pretty much been in that 2.3, 2.4 range for much of the past year. And, again, coming back to what you mentioned, remember these instruments are indexed to CPI which historically has tended to run above the Fed's measure of PCE. So 2.3 to 2.4 is actually right in line with the Fed's 2% PCE target. It's implying again that inflation will come very quickly down to that Fed's 2% target and, and stay there, so incredibly benign sort of inflation expectations there.

Mike Hanson: And do you think that helps then, uh, rationalize why the market's looking for, uh, more Fed easing as we go forward here?

Phoebe White: Yeah, I think it does. And if you look at the OIS market, we're pricing more than two full cuts by the end of this year-

Mike Hanson: Mm-hmm?

Phoebe White: ... implying a terminal policy rate close to 3%.

Mike Hanson: Mm-hmm.

Phoebe White: So we think, if we move through especially the first half of the year and into the second half with inflation staying sticky closer to that 3% level, we could see some of those easing expectations get taken out that should push especially the front end of the both real yield and nominal yield curve higher. So, in our forecast, we have two-year treasure yields ending the year at 385 and 10-year yields at 435, leaving that two's, ten's curve near 50 basis points. So, Mike, I think we covered a lot. I think that's actually a good place for us to wrap. Thank you so much for joining and for sharing your insights.

Mike Hanson: Thank you.

Phoebe White: And, to our listeners, be sure to tune into Making Sense next week when Kate Finlayson, global head of FICC market structure and liquidity strategy, welcomes Sandy Kaul, executive vice president and head of innovation at Franklin Templeton, to discuss the advancements and opportunities in blockchain technology. That episode will be available on Tuesday, February 24th. We'll see you then. Thanks for listening.

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