US inflation slowed to 6.4% year-on-year in January vs 6.5% in December. However, on a month-on-month basis, inflation rose 0.5% in January vs 0.1% in December. Stickier inflation means that the Fed may need to continue increasing rates and keeping them higher for longer.

With a 6.4% year-on-year increase, the January CPI marked the seventh monthly drop in a row. Core inflation, which excludes food and energy, also declined to 5.6% year-on-year in January vs 5.7% in December. However, the month-on-month increase, both for the full CPI (+0.5% vs +0.1%) and for the core inflation index (+0.4% vs +0.3%) suggests that the US economy remains strong with little evidence that the Fed's tight monetary policy has had an impact. The latest unemployment level, at 3.4%, is the lowest in 53 years and the strength of the job market has helped support consumer spending, which underpins the bulk of the US economy.

Unless future data for inflation shows a significant drop, the Fed is likely to keep increasing rates. Market futures expect rates to peak at 5.27% mid-2023, in line with the most recent ‘dot plots’. That would imply a 25bp increase in March and another 25bp in May or June. The resilience of the US economy makes inflation more difficult to tame.

Another risk for inflation may come from China. In 2022, the Chinese economy grew at a mere 3% year-on-year, impacted by the country’s ‘zero-COVID’ policy and by a depressed property market. Project Blue believes that the Chinese economy will rebound strongly in 2023, driven by domestic consumption, and forecasts  5.5% GDP growth, with upside. However, a more robust Chinese economy may also induce inflationary pressures, driven by recovering demand. The risk is, therefore, that inflation will remain higher for longer. Markets are still expecting a rate cut before the end of 2023, a possibility that, in our view, is receding.  The Fed, and the other Central Banks, may also have to revise their long-term inflation targets and question whether a return to a 2% annual rate is realistic.