Last week's report on consumer prices showed that inflation is still elevated but rounding the corner toward more moderate rates.

The overall Consumer Price Index (the CPI) fell 0.1% in December after rising just 0.1% in November. The core CPI — which excludes the direct effects of movements in food and energy prices — rose 0.2% in November followed by 0.3% in December. Twelve-month changes for the overall and core CPIs declined to still-elevated rates of 6.5% and 5.7%, respectively.

The recent easing in inflation is concentrated in energy and nonenergy goods, where prices have been falling. Gasoline prices fell more than 9% in December and are down nearly 28% since July. The core CPI for goods fell 1.2% (not annualized) over the final three months of 2022.

Core services inflation continued to trend higher, boosted by surging rents that rose at approximately a 9% annual rate over the final three months of 2022. We expect rent inflation to fall over the course of 2023 as the stock of leases turns over with smaller rent increases.

Weakness is coming

During a light week for data related to spending and production, we made no change to our prior estimate that GDP rose at a 2.8% annual rate in the fourth quarter, aided by a large increase in inventory investment and reflecting solid growth in personal consumption expenditures (PCE). We expect both components to weaken in the first quarter, when we expect that GDP will decline at a 1.6% annual rate, marking the beginning of a mild recession that we expect will be followed by a recovery beginning in the third quarter.

The CPI report was consistent with our estimate that the core PCE price index rose 0.3% in December, and that its 12-month change eased to 4.5%. Comparable estimates for the headline PCE price index as of December are 0.1% and 5.1%.

Consistent with our forecast for a mild recession this year and softening demand in product and labor markets, we expect continued declines in both headline and core inflation, with annual (4-quarter) inflation rates projected to fall to 2.7% for headline PCE and 3.1% for core PCE, in the fourth quarter of 2023.

Encouragement for the Fed

Policymakers at the Federal Reserve took some encouragement from data that are broadly consistent with expectations for a gradual reduction of inflation. Those data strongly suggest, as we have expected, that the Federal Open Market Committee (FOMC) will opt for a "normal" rate hike of one-quarter percentage point at the upcoming policy meeting that concludes on Feb. 1.

We expect that an additional quarter-point Fed rate hike in March will be the last for this cycle. Those moves would bring the upper end of the target range for the federal funds rate to 5%, implying a cumulative increase since last March of 4¾ percentage points. At that point (in March 2023), the real expected federal funds rate, adjusted for our one-year forecast for core PCE inflation, would be approximately 2%, a substantially restrictive level.

At the time of their December 2022 policy meeting, a majority of FOMC participants expected a slightly higher peak level for the nominal federal funds rate (in 2023) than in our forecast but a broadly similar level for the real federal funds rate. This can be explained by policymakers' expectation that inflation will recede more slowly than in our forecast.

Investors were encouraged by the latest inflation data showing easing over the final few months of 2022. Last week, the S&P 500 gained 2.7%, closing Friday at 3,999.09. Treasury yields drifted lower: the 10-year note yield was 3.50% on Friday, down from 3.55% one week earlier. Futures continue to suggest that investors expect the Fed to begin cutting interest rates this fall, a view that Fed Chair Powell has resisted as being inconsistent with the Fed's commitment to achieving a sustained reduction of inflation to 2%.

This week's economic releases:

• Producer price index for final demand (Jan. 18): We estimate a decline of 0.1% in December, compared with an increase of 0.3% in November. We estimate no change in the core PPI for final demand.
• Retail and food services sales (Jan. 18): We estimate a 0.8% decline for total retail and food services sales in December. Excluding motor vehicles and parts dealers, we estimate a 0.3% decrease. Both figures would be the second consecutive monthly decline following robust gains in October.
• Total industrial production (Jan. 18): Declines in total IP and manufacturing IP in December would be consistent with our view that the US economy is about to tip into a mild recession.
• New residential construction (Jan. 19): We estimate 1,355 thousand housing starts in December, compared with 1,427 thousand in November. This would continue what has been a sharply weakening trend, as housing activity has been weighed down recently by low affordability (high house prices and mortgage rates).
• Existing home sales (Jan. 20): We estimate 3,917 thousand existing home sales in December, compared with 4,090 in November. This would leave sales in line with a sharply weakening trend and at the lowest level since 2010.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.