By Tiffany Wilding and Allison Boxer, US Economists at PIMCO
While the overall pace of core U.S. inflation in December 2021 remained strong, underlying details in the Consumer Price Index (CPI) data suggested some stabilization from the recent reacceleration. This reinforces PIMCO’s outlook for U.S. inflation to begin to moderate, likely peaking in February and then trending back toward the central bank’s target throughout 2022.
The unusual holiday shopping season and recovering travel drove strong price gains in December, while shelter price inflation appears to be stabilizing at an elevated level. Core CPI rose 0.55% month-over-month (m/m) in December, which brought core CPI up to 5.5% y/y – the fastest pace since the early 1990s.
With inflation at multi-decade highs, upside risks to inflation expectations remain elevated. Taken together with the recent drop in U.S. unemployment, it is consistent with PIMCO’s expectations for the U.S. Federal Reserve to start to hike rates in March 2022 and move to further tighten policy by allowing the balance sheet to shrink later this year.
Tighter monetary policy path amid upside risks
The strong CPI report combined with the drop in the U.S. unemployment rate in December (to 3.9%) bolsters our forecast for the U.S. Federal Reserve to begin hiking its policy rate in March and to start winding down its balance sheet later this year.
While our baseline sees inflation moderating toward the Fed’s target through 2022, we continue to see upside risks supporting Fed officials’ decision to tighten policy more quickly than they previously projected. First, we continue to see upside risks to inflation expectations, as the longer inflation stays elevated, the greater the risk that consumers start to adjust their behavior. Second, we see risks from the recent global surge in COVID-19 cases related to the omicron variant. While we expect U.S. real GDP growth to slow in 1Q 2022 due to the virus outbreak as well as the breakdown in negotiations over the Build Back Better fiscal plan, we see risks that supply disruptions cause the inflation outlook for 2022 to rise further. Another disruption to production in China and other key U.S. suppliers would come at a time when U.S. retail goods inventories remain very low, raising the risk of an outsized impact from any further shutdowns.
For further insights into economic growth, inflation, and policy in 2022, along with investment implications, please read our Cyclical Outlook, “Investing in a Fast‑Moving Cycle.”
Key takeaways from December CPI data: retail goods, travel, services, cars
U.S. retail goods price inflation was very strong again in December – household goods (1.3% m/m) and apparel (1.7% m/m) saw particularly strong gains. In general, U.S. retailers successfully navigated a challenging holiday shopping season by warning customers to shop early or face empty shelves. This resulted in lower discounting than usual, and though consumption moderated into the late part of the quarter, retailers helped offset this with fewer discounts.
Elsewhere, improved demand for domestic travel around the holidays drove price gains. U.S. airfares continued to recover from 3Q weakness (+2.7% m/m) for a second straight month, though overall air prices still remain well below pre-COVID levels. While we still ultimately expect airfares to recover, the omicron variant is a near-term headwind. Many companies are once again delaying return-to-office plans, which will likely weigh on higher-priced corporate travel. Hotel prices (+1.3% m/m) continued to surge past pre-COVID levels, as demand remains very strong for drive-to travel destinations while international travel remains more limited.
Outside of travel, U.S. services price inflation was still strong but somewhat more muted in December relative to November. Shelter price inflation (one-third of the CPI basket) moderated from 0.5% m/m in November to 0.42% m/m in December, though rents (0.39% m/m) and owners’ equivalent rent or OER (0.40% m/m) both remained very firm. That said, the stabilization in OER seen in December’s report is important, as it suggests the monthly pace of OER inflation may be flatlining, although still at an elevated level. The softening relative to November was driven by non-cities, which appear to be cooling slightly. Overall this confirms our forecast for OER to peak at about 5%–5.5% y/y.
Finally, auto prices once again were very strong. Used car price inflation jumped to 3.5% m/m while new vehicle prices rose 1.0% m/m. Semiconductor shortages, record low inventories, pandemic demand, and destruction from Hurricane Ida continue to combine in a perfect storm for auto prices. The most recent Manheim used vehicle value index as well as comments from automakers around supply issues continue to point to some improvement in the months ahead, but it will likely take time for inventories to recover.