The Outlook For Consumer Inflation And Interest Rates

Scott Anderson
Chief Economist
Bank of the West

Much to the delight of investors, U.S. consumer inflation growth continues to decelerate from its June 2022 peak of 9.1%. Overall consumer inflation declined 0.1% between November and December – the first monthly decrease since May 2020 – and has moderated sharply over the last two months. The primary cause is declining demand for goods, falling energy and transportation prices, and rapidly improving global supply chains. The New York Fed's Global Supply Chain Pressure Index dropped from 4.30 in December 2021 to 1.18 in December 2022.

Headline Consumer Price Inflation Fell In December

The December decline was driven by a sharp 4.5% drop in energy prices – the largest monthly decrease since August – with gasoline prices plunging 9.4%. There were also big declines in airfares (-3.1%), used cars (-2.5%) and other commodity prices (-2.0%). The news was not all good though as inflation remains too high for housing (+0.7%), services (+0.6%), apparel (+0.5%) and food and beverages (+0.3%).

Energy And Transportation Prices Declined Sharply

Over the past year, consumer prices increased 6.4% on a seasonally adjusted basis through December down from 7.1% in November. The 6.4% December CPI increase is the smallest year-on-year gain since October 2021. Over the past year, the largest price increases have been in food and beverages (+10.1%), housing (+8.0%), services (+7.5%) and energy (+7.0%), while the smallest upturns were in medical care (+4.0%), transportation (+3.7%), apparel (+2.9%) and education (+0.8%).

Price Increases From A Year Ago Were Broad Based

Core consumer price inflation – which excludes volatile food and energy prices and is more closely monitored by the Fed for underlying inflation trends – rose a solid 0.3% in December. While this was in-line with our forecast, it is a slight uptick from the 0.2% increase in November. Nonetheless, the year earlier growth rate in core consumer inflation dropped to 5.7% in December on a seasonally adjusted basis down from 6.7% last September. This is a measurable decline, but still a long way from the 2.0 to 2.5% pace the Fed would find comfortable.

Core Consumer Inflation Growth Has Moderated Notably

So what does this all mean for inflation and Fed funds interest rates going forward? Actually, the December CPI data did little to change our economic, inflation, or Fed interest rate forecasts. In that sense, the markets "bullish" reaction to the December CPI report might have been a bit of an overreaction. Even before this week's CPI report, we expected the Fed would throttle back on the magnitude of their rate increases. So the CPI report only reaffirms our forecast for 75 basis points of additional Fed rate hikes this year in 25 basis points increments at the February, March and May FOMC meetings before an extended pause.

On the inflation front, the continuation of Fed rate increases further into restrictive territory will weigh even more heavily on consumer and investment demand in 2023 cooling the overheated labor market and gradually lower services and core inflation too. Core CPI inflation is expected to slow to around 3.6% by the fourth quarter of 2023 and by the end of 2024 approach the Fed's medium-term target of 2.0%.

Core Consumer Inflation Growth Projected To Slow

The preliminary reading from the University of Michigan Consumer Sentiment Index released this morning, provided some tantalizing additional support for our moderating inflation forecast. The median one-year ahead inflation expectations moderated for the third consecutive month to 4.0% – the lowest level since April 2021. With inflation expectations well-anchored and core inflation moderating, the Fed should be able to begin lowering interest rates sometime in the first half of 2024 allowing for a return to stronger economic growth.

12 Month Inflation Expectations Have Moderated

To learn more, check out this week's U.S. Outlook Report.


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