The inflation report due Tuesday has the potential to ship some unhealthy information

Prices displayed at a grocery store on February 1, 2023 in New York City.

Leonardo Munoz | Corbis News | Getty Images

Just as Federal Reserve officials have grown optimistic that inflation is cooling, news could come that contradicts that narrative.

All market eyes will be on Tuesday’s release of the Labor Department’s CPI, a widely used measure of inflation that measures the cost of dozens of goods and services across the economy.

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The CPI trended down as 2022 drew to a close. But it looks like 2023 will show that inflation has been strong — perhaps even stronger than Wall Street’s expectations.

“We’ve seen surprises on the soft side for the past three months. It wouldn’t be at all surprising if we were surprised on the hot side in January,” said Mark Zandi, chief economist at Moody’s Analytics.

Economists expect the consumer price index to rise 0.4% in January, which would translate to annual growth of 6.2%, according to the Dow Jones. Excluding food and energy, the so-called core CPI is expected to rise 0.3% and 5.5%, respectively.

However, there are indications that the number could be even higher.

The Cleveland Fed Nowcast tracker for CPI components points to inflation growth of 0.65% on a monthly basis and 6.5% on a yearly basis. For the core, the outlook is 0.46% and 5.6%.

The Fed model is based on fewer variables than the CPI report, while using more real-time data than the backward-looking numbers commonly found in government reports. Over time, the Cleveland Fed says its methodology is outperforming other top-flight forecasters.

Impact on interest rates

If the reading is hotter than expected, there are potentially important impacts on the facility.

Fed policymakers are watching the CPI and a variety of other data points for clues as to whether a series of eight rate hikes is having the desired effect of cooling inflation, which hit a 41-year high last summer. If monetary tightening proves not to be working, it could force the Fed to take a more aggressive stance.

However, Zandi said it was dangerous to overstate individual reports.

“We shouldn’t get too fixated on monthly moves,” he said. “Generally speaking, if we look at month-to-month volatility, we should see a sustained decline in annual growth.”

In fact, the CPI peaked at around 9% on an annualized basis in June 2022, but has since declined, falling to 6.4% in December.

But food prices have been resilient, still more than 10% higher in December than a year ago. Gasoline prices have also reversed, with prices at the pump up about 30 cents a gallon in January, according to the AAA.

Even the originally reported 0.1% decline in December headline CPI has been revised upwards and is now showing a 0.1% rise, according to revisions released on Friday.

“If you had a string of lower numbers than expected, can this continue? I don’t know,” said Peter Boockvar, Bleakley Advisory Group’s chief investment officer.

Boockvar said he doesn’t expect the January report to have much of an impact on the Fed one way or another.

“Let’s just say the headline count is 6%. Is that really going to move the needle for the Fed?” he said. “The Fed appears poised to hike another 50 basis points and clearly a lot more evidence is needed to change that. A number certainly won’t do that.”

Markets are currently expecting the Fed to raise its benchmark interest rate two more times from its current target range of 4.5% to 4.75%. That would mean another half a percentage point, or 50 basis points. Market prices also suggest that the Fed will stop at a ‘final rate’ of 5.18%.

Changes in the CPI report

There are other issues that could cloud the report as the Bureau of Labor Statistics changes the way it produces the report.

A key change is that prices are now weighted based on a one-year comparison, rather than the two-year period previously used.

This has resulted in a change in the impact of the various components – the weighting of both food and energy prices, for example, will have a progressively smaller impact on the overall CPI number, while housing construction will have a slightly larger weighting.

In addition, protection will have a stronger impact, increasing from around 33% to 34.4%. The BLS will also rate unbound rental properties more heavily than apartments.

The weights are changed to reflect consumer spending patterns so that the CPI provides a more accurate picture of the cost of living.

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