CPI, Retail Data Not Pretty But May Overstate U.S. Economic Pain

(Bloomberg) -- Faster-than-projected U.S. inflation and an unexpected decline in retail sales at the start of the year may cause some indigestion on Wall Street, but probably don’t mean much pain for the economy.

The core consumer price index, which excludes volatile food and energy costs, rose 0.3 percent in January from the prior month, the biggest advance in a year and exceeding the 0.2 percent median estimate of economists, a Labor Department report showed Wednesday. Separate figures showed purchases at retailers dropped 0.3 percent after a downward revision to December.

Treasuries slumped and investors marked up expectations for Federal Reserve interest-rate increases. The inflation report was hotly anticipated following robust wage data earlier this month that sent yields higher and started a rout in equities that pushed the main indexes into the first correction in two years.

While the retail figures support analyst forecasts that consumption will slow this quarter on the heels of the biggest quarterly advance in more than a year, consumer spending will likely be buttressed this year by wage growth, a tight labor market and tax cuts.

CPI, Retail Data Not Pretty But May Overstate U.S. Economic Pain

“These reports tell two stories: one, that the real economy may not be as strong as we thought, but also that inflation may be a bit higher,” said Paul Ashworth, chief U.S. economist for Capital Economics. “The Fed looks like they’re leaning towards the inflation part of the story.”

Fed funds futures show that the market is now pricing in two full quarter-point increases through the central bank’s September meeting, and that the overall amount of tightening being anticipated for this year and next has rebounded close to levels seen earlier in February. 

In December, Fed officials penciled in three interest-rate increases for 2018 in their most recent set of quarterly economic projections. That already incorporated expectations for a bump in inflation this year -- to 1.9 percent, as measured by the personal consumption expenditures index, which typically runs slightly slower than CPI. Excluding food and energy, PCE inflation was 1.5 percent in December. 

Michael Feroli, chief U.S. economist at JPMorgan Chase & Co., said the new data cement the likelihood of a policy move when the Federal Open Market Committee gathers next month and increase the chances that officials will forecast four interest-rate hikes this year, up from three.

“To the extent markets had been dismissing the idea that inflation could firm, that was a mistake. Now markets are repricing to reflect that inflation risk,” said Feroli, who formerly worked at the central bank. While Wednesday’s data don’t necessarily mean a significant acceleration is coming, “I definitely expect the numbers to continue to push up,” he said.

Meanwhile, Feroli expects better results on consumption later in the quarter, as a strong labor market, rising incomes and lower taxes mean “consumers are in a good position.”

Part of the CPI gain resulted from a 1.7 percent monthly jump in apparel prices, the biggest increase since 1990. Women’s apparel costs rose a record 3.4 percent. Other categories contributing to the increase in CPI included rents and owners’ equivalent rent, which both rose 0.3 percent from December; medical care, up 0.4 percent; and motor vehicle insurance, which advanced 1.3 percent, the most since 2001.

“Outside of apparel, this was a lot of domestically-oriented consumer price pressure, which is a sign the economy is starting to produce more meaningful inflation,” said Royce Mendes, an economist at CIBC World Markets. “Overall the trend is moving in the right direction and it’s going to necessitate a tightening in monetary policy.”

The increase in the core CPI brought the three-month annualized gain to 2.9 percent, the fastest since 2011, according to data compiled by Bloomberg.

What Our Economists Say

Higher-than-expected inflation and weaker-than-expected consumer spending in January start the year off on the wrong foot, but clearly do not establish a compelling trend. Inflation pressures are rising, to be sure, but not as much as the headline (inflated by energy) or even the core (showing residual impact of prior dollar weakening) would suggest. Meanwhile, soft retail sales are probably the result of two factors -- one, adverse weather shuttered sales at the start of the month (e.g. motor vehicles -1.3%); two, January may be a "pause to refresh” after a gangbusters 4Q.

-- Carl Riccadonna and Yelena Shulyatyeva, Bloomberg Economics

Policy makers look at the core CPI to better gauge underlying inflation because food and energy prices tend to be volatile. The latest report showed energy prices rose 3 percent from the previous month and food costs advanced 0.2 percent. The cost of gasoline at the pump has fallen so far in February.

Fed policy makers will also have February CPI data in hand before they next meet March 20-21 in Jerome Powell’s first gathering as chairman. Powell, speaking Tuesday at his ceremonial swearing-in, suggested that the central bank would push ahead with gradual interest-rate increases, and that officials “remain alert to any developing risks to financial stability.”

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