US CPI: analysis of preliminary data points to potential upside surprise

The currency market and the US bond market are in a bit of a pickle, with prices moving in tight ranges or resembling fading oscillations. It seems like all the hot info that came out recently is already baked into the prices:

Hopes for figuring out the next trend are pinned on today's US inflation report. Overall, inflation is expected to pick up slightly, going from 3.1% in November to 3.2% in December. At the same time, core inflation (excluding food, fuel, and other volatile components), according to the consensus forecast, will continue to slow down, hitting 3.8% versus 4% last month. Markets are more sensitive to surprises in core inflation, as its changes have a stronger impact on the Fed's policy; central bank officials, including Powell, have pointed this out multiple times. The deal is that if you base monetary policy on highly volatile data, it's clear that the volatility of interest rates and other Fed policy parameters will increase. Clearly, this volatility will spill over into the economy and financial markets, which is definitely not in the interest of the central bank, whose task it is to smooth out fluctuations. Check out the graph below showing overall and core inflation: the first one resembles swings around the trend, which is represented by core inflation.

To understand what to expect from today's report, consider the following points:

  • The NFP report showed that wage growth exceeded expectations in December, coming in at 0.4% MoM compared to the forecast of 0.3%. Wage growth correlates with changes in consumer inflation.

  • The New York Fed, which weekly forecasts the quarterly GDP growth of the US based on incoming stats, raised the forecast for the fourth quarter from 2.26% in early December 2023 to 2.54% at the beginning of January 2024.

Overall improvements in December data may indirectly suggest that inflationary pressure in the economy may have increased in December.

  • Initial claims for unemployment benefits in December (an employment indicator) again fell in December.

  • Consumer credit sharply increased in November – $23.75 billion (forecast at $5.13 billion). This can be seen as a leading indicator of increased consumer spending in December.

  • The University of Michigan Consumer Confidence Index jumped to 69.7 points in December, the second-highest reading for 2023.

Among the reports that could indicate a negative surprise in December inflation, only the US Services PMI stands out. The overall index dropped to 50.6 points, but a significant contribution to the decline came from the employment component, which plummeted to 43.7 points.

In general, preliminary data and the seasonal surge in consumer spending at the end of November and in December tilt the risks for the CPI report towards a positive surprise. However, in my view, this won't significantly and for long change market expectations for the March easing of the Fed's policy; the market will prefer to wait for data for January and February. If the report disappoints, an asymmetric reaction is likely: the market will be much more willing to factor in a Fed rate cut in March. In this case, the dollar could start to decline intensively along with bond yields, and the search for yield will sharply intensify, allowing the US stock market to refresh recent highs; the S&P could head towards 5000 points.

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