Will tonight's CPI data rebound and contradict the expectations of an interest rate cut?

At the end of last year, the Federal Reserve signaled a "rate cut," triggering a global asset market frenzy. However, at the beginning of 2024, the US non-farm payroll rebounded beyond expectations, and the hawkish FOMC meeting minutes poured cold water on market expectations. Tonight's CPI report will be an important reference for when the Federal Reserve will cut interest rates for the first time.

At 21:30 Beijing time on Thursday night, the US Department of Labor will release the December CPI inflation data. It is widely believed that overall inflation will rebound slightly, while core inflation remains stubborn. Major investment banks have relatively small differences in their predictions for December CPI:

In terms of year-on-year comparison, overall CPI inflation is expected to rebound to 3.2%, slightly higher than the 3.1% in November, marking the third consecutive increase since mid-2022. Core CPI, on the other hand, is expected to decrease from 4.0% to 3.8%, the smallest year-on-year increase since May 2021.

In terms of month-on-month comparison, overall CPI inflation is expected to accelerate to 0.2%, up from 0.1% in the previous month, while core CPI is expected to remain unchanged at 0.3%.

Specifically, the weakening of the base effect and a slight rebound in energy prices may drive overall inflation. As for core inflation, housing inflation is expected to decline slowly, with a stable or slight decrease in month-on-month comparison. After an unexpected increase in used car prices last month, they are expected to fall back, while airfare prices may show strong growth on a month-on-month basis.

Analysis suggests that US inflation is expected to fall towards the Federal Reserve's target of 2% this year, providing support for a rate cut in 2024. This CPI report is unlikely to shake expectations of a rate cut this year. However, if the CPI is hotter than expected, it may keep the Federal Reserve in a wait-and-see mode and potentially delay the first rate cut.

Currently, the CME FedWatch Tool shows that the market's expectation of a rate cut in March has dropped from 80% to 67%. This means that traders have divergent views on the timing of the Federal Reserve's next move, and this week's CPI report will be a crucial factor in influencing the Federal Reserve's next steps. Lauren Henderson, an economist at financial services company StifelNicolaus & Co., pointed out:

If the report meets expectations, it may solidify the expectation of three rate cuts by the Federal Reserve this year. However, if we see some unexpected upward movement, the expectation of a rate cut in March will be shattered, and the rate cut may start in the second half of the year.

Weakening base effect and rising energy prices drive overall CPI rebound

Driven by the increase in energy costs, the overall CPI in December may rise by 3.2% year-on-year, a slight rebound from the 3.1% in November. After an unexpected increase last month, used car prices are expected to fall back, while airfare prices may show strong growth on a month-on-month basis. Barclays pointed out that gasoline, natural gas, and electricity prices will moderately rise, and the contribution rate of energy to CPI in December will increase by 5 basis points, while it decreased by 16 basis points in October. In addition, food inflation will increase by 0.2% MoM, the same as the growth rate in November, but the YoY growth rate will decrease by 0.2 percentage points to 2.7%.

Analysis indicates that if overall inflation rebounds in December, it will be the third rebound since mid-2022. However, the rebound is mainly due to the weakening base effect, which means that energy prices are not experiencing a significant YoY decrease compared to the previous year's high base. Instead, minor fluctuations in energy prices will cause the overall CPI to rebound or fall.

High Housing Costs and Stubborn Core CPI

Core inflation is expected to remain stubborn, with the largest component, housing inflation, showing slow decline and a predicted unchanged or slight decrease MoM. Used car prices unexpectedly rose last month but are expected to return to a downward trend, while airfare prices may show strong MoM growth due to holiday factors.

Specifically, housing costs, which account for one-third of CPI weight, rose by 0.4% MoM in November, and the growth rate in December is expected to remain high. Barclays predicts that housing inflation will remain almost unchanged MoM, possibly only decreasing by a few basis points. Among them, accommodation prices for those living away from home are expected to decline for the third consecutive month, while rental prices and owner's equivalent rent (OER) are expected to slightly decrease.

UBS also points out that rental prices and OER will continue to grow strongly, roughly in line with the average level of the past six months, and predicts that rents will rise by 40 to 50 basis points at least until March. Nomura believes that rental prices and OER inflation will slightly decrease, but it also notes that the decline will be slow.

It is worth mentioning that housing inflation is a lagging indicator, lagging behind changes in rental prices. Looking ahead, many economists expect that the decline in rental prices will be revealed in the inflation reports in the coming weeks and months.

Secondly, after an unexpected rise in used car prices last month, they are expected to return to a downward trend.

Nomura states that tightened credit conditions and increased price sensitivity among consumers have pushed down used car prices. New car prices may remain unchanged, and the growth brought by promotional incentives will be slower than expected, with a moderate MoM growth of 0.2% in December. Goldman Sachs expects used car prices to decrease by 1.1% in December, and new car prices to decrease by 0.2%. And due to the holiday factor, airfare prices may experience strong growth. Goldman Sachs predicts that airfare prices in December will increase by 5% MoM, while Nomura believes that they may experience strong growth of 5.3%. Barclays points out that with the strong inflation in categories such as motor vehicle insurance and the rebound in airfare prices, transportation service inflation in December will continue to strengthen.

Overall, core commodity prices continue to decline, while inflation in the service industry and housing sector remains severe. The "super core inflation indicator" closely monitored by the Federal Reserve may maintain a MoM rate of 0.4%. The CPI report for December may remind people that there is still a long way to go before inflation drops to 2%.

Looking ahead, UBS predicts that the slowdown in rent increases, the decline in car prices, the easing of supply conditions, and the slowdown in wage growth will exert downward pressure on inflation. Core CPI inflation will decline for most of the next year. The latest survey released by the New York Fed shows that inflation expectations have decreased across the board, reaching the lowest point in three years.

How will CPI affect the Federal Reserve's interest rate path?

Analysis indicates that the trend of rate cuts by the Federal Reserve this year is difficult to reverse, and CPI data may influence the timing of the first rate cut.

Atlanta Fed President Bostic recently stated that the decline in inflation has exceeded his expectations and is progressing smoothly towards the Fed's 2% target. The market previously expected the Fed to make its first rate cut no later than March. Tonight's CPI report will be an important reference for whether the Fed will cut rates in March.

UBS points out:

Even if CPI exceeds market consensus, it will not change the FOMC's path. The slowdown in inflation is significantly faster than what the FOMC expected last year. The threshold for shaking the overall trend is high, and strong CPI data alone is not enough.

Nomura states:

In the medium term, inflation will continue to decline, but it will be more challenging to further slow down from the current level. In addition, as shown in the minutes of the December FOMC meeting, concerns about further easing of the financial environment may make the "last mile" towards 2% inflation more difficult.

Changes in financial conditions take time to affect inflation. With stable core CPI inflation in December and continued loose financial conditions, this should reduce the possibility of a rate cut in March, with the first rate cut expected in June.

Barclays analyzes the gap between core CPI and PCE and points out that the FOMC will start cutting rates in June, with a total of three 25 basis point cuts this year.

The expected increase in core CPI in December brings the average inflation rate from June to December to 2.9%, well above the 2% inflation target. This is in stark contrast to core PCE, which is a full percentage point lower than CPI. Considering the significant difference between the two indicators, we believe that the FOMC needs to see more evidence of inflation continuing to fall towards the 2% target before implementing loose policies.

How will the US stock market react?

With the decline in expectations of interest rate cuts, the market sentiment is cautious. The main risk tonight is an unexpected increase in CPI. Analysts point out that if the core CPI MoM exceeds 0.3%, it may lead to many people cutting losses and exiting the market.

Goldman Sachs trader Cullen Morgan has made the following predictions about market reactions:

In addition, the options market implies that the volatility of the S&P 500 today is 0.67%, the lowest since September last year.