In December the headline US consumer price index (CPI) dropped by 0.1%—the first month-on-month decline since the coronavirus-induced downturn in early 2020. Core inflation, however, continued to rise by 0.3% month on month, maintaining its recent pace.

Why does it matter?

Investors have eagerly awaited a significant slowdown in inflation as a sign that the Federal Reserve (Fed, the central bank) might pause its tightening cycle. Although the month-on-month drop in the index appears to deliver that slowdown, beneath the surface the signals are more mixed. We expect the Fed to continue to moderate its rate increases in 2023, to 25 basis points per meeting, down from a 50-basis-point increase in December and 75 basis points prior to that. However, the end of the tightening cycle is still some way off. We expect the fed funds rate to peak at 5-5.25% in May 2023, implying another 75 basis points of tightening in total. 

We still expect inflation to decelerate only gradually over the course of 2023. The drop in the headline index was largely due to a steep drop in the energy sub-index, including falling prices for gasoline and other fuels. We do not expect substantial further declines in global oil prices in 2023, which will keep a floor under this sub-index in 2023. Meanwhile, food prices continued to rise in December, albeit at a slightly slower rate than in previous months, of 0.3%.

Crucially, core inflation continued to rise by 0.3% in December, maintaining the pace seen in the previous two months. This steady pace is a greater cause for concern, as it reflects the impact of still-strong consumer demand, the trickling through of higher input costs and rising wages. The shelter index, which includes rent and mortgage costs, was the main contributor to inflation in December, as it has been in recent months. Shelter service costs rose by 0.8% month on month—a rapid pace, reflecting the impact of interest-rate rises and strong consumer demand. 

Overall demand for services, and therefore growth in service costs, are likely to persist as long as US consumer demand and the labour market remain strong. Shelter costs are only likely to begin falling more noticeably in the second half of 2023, once previous interest-rate rises filter through rental contracts more fully. 

What next?

We maintain our view that headline US inflation will slow to about 3.6% in 2023—down significantly from 8% in 2022 but still well above normal levels and the Fed’s 2% target. We expect the Fed to make three more 25-basis-point rate increases in February, March and May 2023, before pausing at a peak target range of 5‑5.25%. 

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