US CPI is better but still “sticky” and December labour force data could be pivotal for the RBA

Stephen Miller
US CPI: better but still “sticky”. The Fed policy rate: ditto. Where to for US bond yields?
The robust December payrolls report was something of a death knell for a further Federal Reserve (Fed) easing in January and while last night’s release of the December consumer price index (CPI) was a little better than expected it is not in my view so good as to bring a January easing back into favour.
Certainly, it is clear that there has been little progress on inflation (indeed there has been some deterioration) since the Fed commenced the easing process in September 2024.
That said it was good enough to erase any notion that the Fed might not ease in 2025, a notion which had got some airplay in recent days.
And despite the better than expected number providing for something of a sharp relief rally for US bond yields and an attendant strong rebound in equity indices, I fear that such respite might only be temporary.
The December CPI report revealed a core inflation rate of what is a still relatively elevated 3.2 per cent. Moreover, measures of the “inflation pulse” indicate ongoing “stickiness” in inflation. The 3-month annualised core CPI was 3.3 per cent in December from 3.1 per cent in September compared with a trough of 1.6 per cent in July 2024. The 3-month annualised Cleveland Fed trimmed-mean measure rose to 3.3 per cent in December from a trough of 2.0 per cent in July 2024 and compares with 2.8 per cent in September.
The December CPI does little to diminish some concern regarding the “stickiness” of services inflation even if there were some modest improvement evident in the month. The 3-month annualised rate of services inflation (or “pulse”) was running at 3.8 per cent from 4.4 per cent in September, while the “services less rent-of-shelter” measure (a favoured focus of Chairman Powell) was running at 3.5 per cent from in December from 3.0 per cent in September.
The Fed has already signalled a greater degree of circumspection in respect of future policy rate reductions. That much was evident in the Fed’s FOMC meeting minutes from the December meeting.
The December “dot plot” wound back the median expectation for policy rate cuts for 2025 from 100 basis points (bps) to just 50 bps. That took the median projection to 3.9 per cent for end 2025 from the 3.4 per cent projected back in September.
Markets now seem even more sceptical, with pricing indicating a little more than one further 25 bp rate cuts for 2025.
The “stickiness” of inflation may mean that US bond yields are not yet out of the woods.
Certainly, the incoming Trump Administration’s weaponising of trade through tariffs will simply reinforce fears of not just “sticky” inflation but its potential reacceleration.
Large scale cuts to immigration and the prospect of “mass deportations” might also have a similar effect.
Also, among the herd of elephants in the bond yield room is the already gargantuan US budget deficit at 6 per cent of gross domestic product (GDP). That the US is running such a deficit when the economy is close to full capacity may well excite a resurgence “bond vigilantism”.
That the incoming Administration might add to the deficit with tax cuts, however desirable from a structural viewpoint, will only add to those fears. That is unless Elon Musk et al pull off large expenditure dividends through his government efficiency drive. But those proposals remain somewhat inchoate at this stage.
It now seems certain that bond investors will be asked to swallow a gargantuan amount of bond issuance that is needed to fund a budget deficit of such an extraordinary magnitude. In so doing the bond market will likely develop episodic and potentially severe bouts of indigestion that have the potential to again send yields higher.
And with equity markets still pricing a relatively benign scenario it might be that the headwinds from higher bond yields might still yet elicit future challenges.
RBA: December labour force data could be pivotal. I expect a policy rate reduction at the RBA February meeting
Yesterday’s December labour force is potentially pivotal in deciding which way the Reserve Bank of Australia (RBA) Board jumps at its meeting on 17-18 February.
At this stage my best guess is that the RBA will be persuaded to reduce the policy rate from 4.35 per cent to 4.10 per cent at that meeting.
That is based on a view that the annual increase in the December quarter consumer price index (CPI) will certainly be no higher – indeed probably lower – than the RBA’s November projection of 3.4 per cent
Against a background of weak private sector economic activity and slowing wage growth, an anticipated better than expected CPI should allow the RBA the requisite confidence that inflation is in the words of the Board “moving sustainably towards target”.
There has been some reticence among a number of commentators in forecasting a policy rate reduction in February because of the apparent resilience of the labour market.
Just a couple of days after the conclusion of the last RBA Board meeting in December the release of the November labour force report showed continued growth in employment and a decline in the unemployment rate to 3.9 per cent.
Even allowing for a question mark over the “quality” of employment growth – concentrated as it is in the public sector – the unemployment rate is well below what the RBA has articulated as an estimate of the non-accelerating inflation rate of unemployment (NAIRU) of around 4.5 per cent.
The implication is therefore that the RBA cannot be confident “that inflation is moving sustainably towards target” until the unemployment rate is close to 4.5 per cent.
There are a few difficulties with that premise.
With a manifestly weak economy, the apparent strength in the labour market is fragile and should it give way we may well see a rapid increase in the unemployment rate, as occurred in the 1982 and 1991 recessions.
The Board has noted for some time now the “risk that any pick-up in consumption is slower than expected, resulting in continued subdued output growth and a sharper deterioration in the labour market.” There is, as yet, no evidence of that “sharper deterioration in the labour market” but nor is there much evidence of any pick-up in household spending.
In any case, a deterioration in the labour market remains a non-trivial risk and one to which the RBA would certainly need to respond.
That said, market expectations are for a modest 15k increase in employment and a more or less “corrective” (but not troubling) rise in the unemployment rate to 4 per cent. My view is that such an outcome would not prevent a policy rate reduction.
My fear is that there may well be a sharper deterioration in the labour market.
Putting those fears to one side, why might an outcome in line with the market consensus still elicit a policy rate reduction in February?
It all gets back to assessments of the NAIRU.
What has hitherto received little attention is that for whatever reason the NAIRU might well be below current RBA estimates of around 4.5 per cent.
The NAIRU is a notoriously difficult item to measure accurately, but a NAIRU of say around 4 per cent or lower would be consistent with the already observed slowing wages growth.
It may not stay there for long given policymaker timidity when it comes to structural policy initiatives, but in the short-term the RBA’s approach is focussed more heavily on the cyclical rather than the structural.
The strong likelihood of a December quarter trimmed-mean inflation print (released on 29 January 29) at or below the RBA’s forecast of 3.4 per cent will consolidate confidence that inflation is returning to target.
If the RBA were also to revise downwards the NAIRU, that would remove the final hurdle to a policy rate reduction in February.
So, with the CPI slower, if the NAIRU is lower a February rate cut is a goer!
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