CPI Overview: Further Disinflation Puts Fed In Comfortable Position

Summary

The January inflation report indicates a cooling headline inflation rate, confirming a steady downward trend that places the Federal Reserve (Fed) in a favorable position. Despite this, persistent underlying pressures remain, particularly in service-sector costs and volatile categories like travel. The disinflationary impulse from energy prices has contributed to this comfortable stance, but the Fed is expected to remain patient and vigilant.

Headline vs. Core Inflation Dynamics

• Headline Inflation: The "All items" index rose by 0.2% month-over-month (MoM) in January, a slight deceleration from December's 0.3%, resulting in an annual inflation rate of 2.4%.
• Core Inflation: Excluding food and energy, prices increased by 0.3% MoM (up from 0.2% in December), maintaining a yearly rate of 2.5%.

Significant Month-over-Month Changes (Dec 2025 to Jan 2026)

• Energy Prices: Experienced a sharp decline of 1.5% MoM, primarily due to a 3.2% drop in gasoline prices.
• Service Sector: Costs rose by 0.4% MoM, with airline fares surging by 6.5%, up from a 3.8% increase in December.
• Housing & Shelter: Shelter costs grew by 0.2% MoM, down from 0.4% in December, indicating a deceleration in the housing sector.
• Overall Goods Deflation: Used cars and trucks saw a decline of 1.8% MoM, while apparel prices increased by 0.3%.
• Tariff-sensitive Categories: Prices for furnishings rose by 0.7%, appliances by 1.3%, video and audio equipment by 2.2%, and computers and software by 3.1%.

Implications for the Federal Reserve

The latest inflation data provides the Federal Open Market Committee (FOMC) with significant flexibility to consider monetary easing without feeling rushed. The cooling headline rate, supported by a drop in gasoline prices and subdued food inflation, helps anchor consumer inflation expectations. The deceleration in shelter costs offers relief for the core services sector. However, more hawkish committee members may remain cautious due to persistent core inflation dynamics and inflationary pressures in tariff-sensitive goods.

Market Reaction

U.S. Treasuries rallied significantly, with 10-year yields falling to their lowest in three months (around 4.06%). Futures on 10Y Treasury Notes reached their highest since early December 2025. Federal Funds Futures indicate that short-term rate cut expectations remain stable, with probabilities for rate cuts in the first half of 2026 showing approximately 10% for March, 35% for April, and 90% for June. The longer end of the curve has turned more dovish, with markets pricing in 2.56 rate cuts before the end of 2026, up from 2.3 a week prior.

Conclusion

The CPI report has influenced the strength of the dollar, clearing previous gains in the USDIDX, although overall volatility in the foreign exchange market was limited. The combination of progressing disinflation and a stable labor market provides the Federal Reserve with the necessary space to adjust to risks on both sides of their mandate.