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Inflation was always likely to rise above 7% in December given the forces at play within the used car and housing markets, but despite the release showing that headline inflation is sitting at its highest point since June 1982, the reaction in the Treasury market was counterintuitive and the dollar sold-off against its G10 peers.
We flagged the asymmetric risks for market pricing heading into today’s release as elevated expectations of Fed normalisation needed the report to show both a broad-based increase in inflation, along with underlying pressures showing rapid sequential growth such that the impact of Omicron won’t undo the rise in inflation in January.
Unfortunately for those that were short front-end Treasuries and long USD heading into today’s release, this wasn’t evident despite the record-breaking YoY figures and the growth in the core CPI rate outstripping headline CPI by 0.1pp with a MoM increase of 0.6%.
Front-end rates dip following the US CPI release while the dollar takes on water across the board
The problem with today’s CPI release was that the increase in inflation was driven by narrow factors, with some set to exhibit slowing price growth in the coming months.
Used car and truck prices, which rose at a rate of 3.5% MoM in December, are an example of this. Supply pressures in the new vehicle market are set to fade in the coming months, and with auction prices in the used car market showing signs of moderating, it is only a matter of time until this component stops driving the continued rise in core inflation. For context, the increase in used vehicle prices contributed around 1.6pp to the 5.5% increase in core inflation YoY in December. Meanwhile, measures of more broad-based inflationary pressures, such as the increase in food prices, showed signs of moderating after averaging price increases of 0.8% MoM in Q4 up until December’s print of 0.5%. This wasn’t due to seasonal adjustments due to the Christmas period either, with the unadjusted data showing a much more severe reduction in price growth. Meanwhile, the increase in prices in travel-related sectors also moderated, and is set to slow more substantially in January as the impacts of Omicron filter through. This dynamic was also visible in other sub-components like recreational services, recreational commodities and recreation services which are highly exposed to the underlying health backdrop.
Looking ahead, today’s inflation report signals an unsettling narrative for financial markets that have run with the idea of not only 4 rate hikes from the Fed this year, but quantitative tightening as well.
In order for these expectations to hold, and especially become more entrenched in asset pricing, inflation releases throughout Q1 will need to show substantial supply constraints filtering through due to Omicron that more than offset the slump in demand and the likely continued reduction in energy prices. While we don’t think today’s CPI release will derail the Fed’s likely lift-off in March, continued reports of narrow inflation pressures will likely lead markets to trim expectations of the normalisation cycle across 2022 as a whole, which will undoubtedly result in sustained USD depreciation.
Inflation pressures narrow ahead of January’s CPI release which will likely show the impacts of Omicron
Author: Simon Harvey, Senior FX Market Analyst