Will Core CPI Stick Around?

US inflation is expected to have fallen further in December, but stickiness in the core reading could open the possibility of a more extensive hike by the Fed.

What the markets are expecting

The consensus among analysts is that US inflation in December was 6.5% annualised, which would be substantially lower than the 7.1% recorded in November. The number has come in quite below consensus twice a row, and analysts are now adjusting. While reduced inflation might help in other areas of the economy, the Fed cares more about core inflation, which doesn't consider the more volatile food and energy prices. 

In the past couple of months, core inflation has been falling, largely thanks to an unexpected drop in the cost of housing. Now core CPI is expected to drop to 5.7% compared to 6.0% prior, half the move as the headline number. This suggests that the more critical core rate is reacting slower and could keep opening the possibility of the Fed raising rates more significantly than the market expects.

The market against the Fed - and the ECB

The Fed's Inflation Nowcasting is forecasting a less dramatic drop in inflation. Headline CPI inflation is expected to come in at 6.6%, but the key core rate is expected to move relatively little, ticking down to 5.9%. Apparently, the market expects inflation to come down faster than the Fed, which could partially explain why the Fed expects a higher terminal rate than the market. A higher-than-expected inflation rate could cause a reevaluation of Fed expectations to the upside. Currently, more than three-quarters of economists expect just a 25bps hike at the next meeting.

Meanwhile, the messaging from the ECB has been reasonably consistent that more needs to be done to fight the higher inflation in the shared economy. Though just yesterday, ECB member Centeno somewhat broke ranks, suggesting that the shared central bank was close to ending rate hikes. The shifting expectation that the euro area could avoid a recession gives the ECB more room to continue hiking, which could further support the Euro against the dollar. That is, unless there is a surprise with the inflation data.

EUR/USD

Eurodollar has breached the upper trendline of a bullish flag pattern at $1.07; it brings $1.0953 on the table as it is the projected level of the measured move. Bulls failing to hold $1.07 will open the door to $1.0483. In the interim, $1.0595 could offer support if not a reversal back up. However, taking control of the $1.08 handle will favour a bullish bias, with the round $1.09 a key level before the target. In the short term, bulls need prices above 1.0736.

Source: Spreadex

Key takeaways

Inflation is falling, supported by the fall in house prices, but core reacts slower and the Fed expects a slight change compared to analysts. If inflation is upbeat, it could cause the Fed to reevaluate its upward terminal rate expectations. Meanwhile, the ECB is under pressure to continue raising rates to fight high inflation in the euro area.