January CPI Report - Too hot to dismiss

The January CPI print was much hotter than expected and will likely make for a very uncomfortable reading for the Federal Reserve. While technical and one-off factors have added noise to January’s print, the combination of last week’s upside surprise in average earnings growth, today’s sharp increase in supercore services inflation, and the U.S. government’s policy agenda threatening to raise inflation expectations is too significant to ignore. If inflation pressures persist in the coming months, they could even prevent the Fed from cutting rates this year.

 Report details

• Monthly headline inflation rose 0.5% in January, much hotter than expected and the biggest monthly increase since August 2023, bringing the annual rate to 3.0%—from 2.9% prior. Core inflation, which strips out food and energy, also came in higher than expected, increasing 0.4% in the month, seeing the annual rate accelerate to 3.3%. Despite showing some improvement last month, the recent run-rate of monthly inflation rebounded strongly, as the three-month annualized pace of core inflation rose to 3.8%—the highest level since April 2024.
• Food prices increased 0.4% in the month, with four of the six major grocery store food group indices—including egg prices, which rose by 15.2% amid the widening spread of bird flu—notching an increase. Meanwhile, energy prices rose 1.1%, led by an increase in gasoline prices, which rose 1.8%. The increase in both food and energy prices contributed about a quarter of the monthly rise in headline inflation.
• Core inflation remained predominantly driven by services prices, which rose 0.5%. Shelter rose 0.4% and drove nearly 30% of the increase in headline inflation, as lodging away from home rebounded from deflation last month while owner’s equivalent rent remained firm, rising 0.3%. Shelter inflation remains the primary challenge to the ongoing disinflationary process, and while it has decelerated compared to late last year, progress has been painfully slow. Meanwhile, auto insurance also continued to exhibit stickiness, accelerating to 2%.

• Core goods inflation re-accelerated to 0.3%, the highest since May 2023, as used car and truck prices soared by 2.2%—potentially an effect of the California wildfires—largely offsetting the decline in apparel prices. While core goods were a source of outright deflation for much of 2024, its continued increase at this pace and risks around additional tariff hikes, could complicate the disinflationary progress policymakers are looking for.
• The Fed's preferred supercore inflation measure, which excludes shelter from core services, surged by 0.8% in the period, despite base effects leading the annual rate to decline from 4.1% to 4.0%. Combined with average earnings growth surprising to the upside last week, the rise in supercore inflation could be a potential signal that wage costs may again be contributing to price pressures.
• In accordance with its annual practice, the BLS revised its seasonal adjustment and component weight calculations to reflect updated data. However, residual seasonality remains a potential issue, as January typically sees an acceleration in inflation as firms reset prices, adding some noise to the otherwise strong price gains.

Policy outlook

Today’s inflation report will not be received well by either policymakers or investors. The disinflationary progress in shelter inflation remains painfully slow, if not at risk of stalling. At the same time, lower goods prices may no longer be a reliable source of disinflation amid the risk of additional tariff hikes.

Though technical and one-off factors may have played some role in the upside surprise, the sharp rise in supercore inflation—potentially signaling that wage costs could again be problematic—coupled with the new administration’s bold policy agenda which could threaten to unmoor inflation expectations—makes the upside surprise too convincing to dismiss. With the Fed closely monitoring inflation risks, these developments may be consistent with the Fed prolonging its pause into the second half of 2025.

Principal Asset Management