Inflation Cools as 2023 Ends: What It Means for the Economy and the Fed

Inflation has been a persistent concern since the early days of the Covid-19 pandemic, with price increases reaching levels not seen since the early 1980s. The Federal Reserve initially believed this surge in inflation to be temporary, when that view turned out to be wrong, it responded with a series of interest rate hikes, pushing its benchmark rate to its highest level in over two decades. However, recent data suggests that inflation is cooling, potentially allowing the Fed to shift its policy direction.

December’s Inflation Data

On Friday, the Commerce Department released the personal consumption expendituresPCE stands for Personal Consumption Expenditures. It is a measure of how much money households spend on goods and services. More price index for December, an important metric closely watched by the Federal Reserve. The data showed that inflation slowed as 2023 drew to a close. In December, the index increased by 0.2% on a monthly basis and by 2.9% on a yearly basis when excluding food and energy prices. Economists had anticipated slightly higher increases of 0.2% and 3%, respectively.

Breaking down the numbers, core inflation (excluding food and energy) increased from 0.1% in November, but the annual rate dropped from 3.2%. This decline marked the lowest 12-month rate since March 2021. When including volatile food and energy costs, headline inflation also rose 0.2% for the month and held steady at 2.6% annually.

Implications for the Federal Reserve

The release of this data adds to the growing evidence that while inflation remains elevated, it is gradually moving lower. This trend could potentially provide the Federal Reserve with the confidence to begin cutting interest rates later in 2023. The central bank aims for an annual inflation rate of 2% as a healthy target.

As inflation inches closer to the Fed’s target, consumer spending has seen a boost, with a 0.7% increase, surpassing the estimated 0.5%. Personal income growth moderated slightly to 0.3%, in line with forecasts.

However, the data also suggests that consumers are dipping into their savings to cover their expenditures. The personal savings rate fell to 3.7% in December, down from 4.1% in November.

Factors Behind the Inflation Trends

Examining the inflation numbers, prices for goods declined by 0.2%, while services prices rose by 0.3%. This reversal of the trend observed during the pandemic, when demand for goods surged, added to supply chain challenges and contributed to rising prices.

Food prices increased by 0.1% for the month, and energy goods and services rose by 0.3%. Meanwhile, prices for durable goods like appliances, computers, and vehicles decreased by 0.4%.

An Expanding Economy and Inflation Outlook

Considering a separate report released the previous day, which indicated that gross domestic product (GDP) grew at a faster-than-expected pace of 3.3% in the fourth quarter, the latest data paints a picture of an expanding economy and a trajectory toward the Fed’s 2% annual inflation target.

This combination of factors suggests that the Federal Reserve may be poised to adjust its monetary policy in response to these trends. The central bank’s benchmark overnight interest rate currently sits between 5.25% and 5.5%. As inflation trends closer to the Fed’s target, the conditions may be ripe for a policy pivot, which could involve a multiyear campaign to reduce the policy rate to a range between 2.5% and 3%.

Market Response and Future Expectations

Despite the significance of this data, financial markets did not show dramatic reactions. Stock futures indicated only a slight change at the open, and Treasury yields mostly trended lower. This muted market response suggests a cautious wait-and-see approach among investors.

In conclusion, the latest inflation data indicates a cooling trend, potentially paving the way for the Federal Reserve to adjust its monetary policy later in 2023. While the public often follows the Labor Department’s consumer price indexThe Consumer Price Index is a measure of the average price level of a basket of goods and services that are commonly consumed by households. More (CPI), the Fed relies on the personal consumption expenditures price index for its policy decisions, as it accounts for shifts in consumer spending patterns. As the inflation rate moderates and the economy expands, Fed officials may soon recalibrate their policy stance to align with the evolving economic landscape.