The consumer price index falls for the sixth consecutive month

Inflation has been the most vexing economic challenge for the average American household over the past year. Despite a red-hot labor market and unusually strong wage gains, surging prices have chewed away at the purchasing power and standard of living for American consumers. There are growing signs that’s changing.

The consumer price index fell for the sixth consecutive month, dipping to 6.5% in December as the broadest gauge of consumer inflation edged lower by 0.1% for the month. The drop was the first outright monthly decline since May 2020.

Falling energy prices certainly played a meaningful role, its 4.5% drop for the month reflecting a decline in demand. Food prices increased, but there are signs that the pace of gains may also be starting to break. For the year, food prices rose by more than 10% — a source of frustration for all consumers but particularly for lower-income households that devote a higher portion of their spending budget to food.

Setting aside food and energy prices, which tend to be more volatile, core consumer prices rose by 0.3% in December. The year-on-year core reading edged lower for the third consecutive month to 5.7%.

Core inflation continues to be distorted to the upside by housing costs, which are reflected in the index at a considerable lag relative to the real-world experience. Other measures of housing have rolled over, and CPI-based measures of housing costs should ease as the year progresses.

The December report on prices offers a reassuring message that the worst of the inflation story may be in the rearview mirror — a combination of Fed tightening, normalization of global supply chains and scattered shortages, and the global economic slowdown all playing a role.

At the same time, the report also confirms that there’s more work to be done to get the inflation genie back in the bottle. Despite the decline, inflation remains quite elevated and well above the Fed’s 2% target. Service sector inflation in particular remains a concern given tight labor conditions and rising labor costs, which are particularly significant to service businesses. The risk of a negative feedback loop from rising labor costs feeding into service sector inflation is real, and one that goes to the heart of the Fed’s focus on softening up job market conditions.

For the Fed, lower inflation alone isn’t likely to prompt the Fed to deviate from its prescribed tightening path in the near term, particularly given the persistent tightness in labor market indicators. Layoffs and the unemployment rate remain very low, and job openings remain quite high. Given the Fed’s dual mandate, a more meaningful softening in labor demand and wage growth will be needed. Fed chair Powell previously described the need for some “pain” to achieve these goals; thus far, any pain in the jobs market has been relatively limited compared to the uptick in unemployment forecast by the Fed — a forecast that may even prove optimistic if the economy slips into recession in 2023 as is widely anticipated. Unemployment has risen by an average of 2.7% in recessions in recent decades. Whether the Fed can successfully navigate a softer landing for the jobs market remains to be seen, but the historical track record is telling.

Fed policymakers have been consistent in their inflation-fighting rhetoric, consistently reconfirming an intent to keep tightening until inflation recedes to 2% and meaningful slack is created in the labor market. Layoff announcements have ramped up but aren’t yet considerably moving the needle on jobless claims, likely due to the abundance of available jobs. Much will hinge on the degree to which momentum in job creation falters in the coming months. The Fed is looking for this and appears committed to further rate hikes until they see it.

The bottom line? Inflation pressures are easing and appear well positioned to fall further in the coming months. A reasonable path can be seen to sub-4% headline inflation by the middle of the year; a return to 2% looks a bit more challenged.

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