The US inflation report in January was well above expectation for both headline data and core measures, providing further evidence that the momentum in inflation is picking-up. Here I analyse the data in detail, explore the outlook and discuss the market implications.
US headline Consumer Price Index (CPI) was up 0.5% month-on-month (MoM) (vs +0.3% expected) in January, due to the rise in energy prices over the month; and remained at +2.1% on a year-on-year (YoY) basis (vs +1.9% expected). Core CPI (excluding energy and food) also beat estimates as it picked up +0.3% MoM (vs +0.2% expected) and remained at +1.8% YoY (vs +1.7% expected). Ahead of the inflation release, there was some chatter that the January figure was going to be lower due to technical factors like seasonality and a high base in comparison to last year. So the jump in CPI estimates is of significance to markets, especially after the outsized gains in wage growth in January.
The higher than anticipated performance in core CPI mainly came from apparels, medical care services and transport services. The contraction in apparel CPI abated notably in Jan (from -1.7% YoY to -0.7%), and is likely to continue as the apparel producer price index has been trending higher due to the weaker US dollar. Medical care services prices picked-up from +1.6% to +2.0% YoY, while transport services prices increased from +3.7% to +4.0% YoY in January. These increased positive contributions were offset by weaker medical care goods and new vehicle prices. Meanwhile, heavy-weight CPI items like accommodation remained stable YoY.
Today’s US CPI report provides further evidence that the momentum in inflation is picking-up. The three month annualised rate of core CPI rose to +2.9% which is the highest since 2011, with both core goods and core services prices firming. If US CPI can rise gradually by +0.2% MoM over the next couple of months it will be on track to reach +2.5% YoY in the second quarter, especially as March 2018 will be compared against a low reading of core CPI which started to weaken in March 2017.
Although the current momentum in US inflation is not alarming, the tightness in the labour market and the late-cycle fiscal boost will increasingly test markets nerves on the Fed’s reaction function. At the time of writing, markets are pricing in about three rate increases in 2018 which is in line with that of the Federal Open Market Committee (FOMC). However, market rate expectations two years and three years out remain well below the FOMC’s median projections. Hence, we think there is room for longer-term bond yields to rise further, given the combination of continued economic growth, higher inflation and higher treasury supply.