U.S. headline Consumer Price Index (CPI) inflation rose 0.1% in December, bringing the year-over-year figure to 2.1% for 2017. While this level is in line with what we saw in 2016, the apparent stability masks a roller coaster over the year for core CPI – the component excluding energy and food prices that markets and economists follow to gauge the underlying inflation trend.
Idiosyncratic factors drove swings in core CPI
While core CPI dropped to 1.8% year-over-year in the December print from 2.2% in December 2016, most of the deceleration happened between March and July, driven to a large extent by idiosyncratic shocks. For example, core CPI dropped by 0.12% in March because of a massive one-off drop in wireless prices. Overall, inflation was slow in the first half of 2017 before bouncing back nicely in the second, ending 2017 on a firm note with December’s 0.3% month-over-month bump in core CPI. This was the second-largest increase of the year and lent support to an annualized rate of 2.25% core CPI for the second half.
Used cars were one of the largest contributors to December’s rise, with a 1.4% monthly increase directly related to the roughly 400,000 cars lost during the hurricane season. Taking out the impact of car prices, core CPI for the past six months rose at a 2.1% pace. This trend is in line with where we see core CPI heading for 2018.
What’s ahead for 2018?
Indeed, we expect core CPI of around 2.1% by the end of 2018 – a modest acceleration relative to 2017. Similarly, we expect the Federal Reserve’s preferred measure of inflation, core personal consumption expenditure (PCE), to accelerate as well, ending the year at around 1.75%, 25 basis points below its target.
A few potential tailwinds could materialize, pushing inflation above our base case. The general strength of the global economy, a weaker dollar and the recent increase in energy prices are all pointing toward higher import prices, which would feed into goods inflation. And last but not least, tax reform (which is mostly tax cuts) could stimulate an economy with limited spare capacity and trigger an acceleration of inflation.
Even if inflation fails to reach the Fed’s 2% target, we believe it should be sufficient to allow for three rate hikes in 2018. But with 10-year and 30-year inflation breakeven rates at 2% and running very close to the core CPI trend, we don’t see much inflation risk being priced by market participants.
For more of PIMCO’s views on the complex drivers of inflation in the U.S. and globally, please visit our inflation page.
Jeremie Banet is a portfolio manager on the real return team and is a regular contributor to the PIMCO Blog.