Why January inflation always looks bad

Markets have a bad habit of overreacting to January inflation figures. January consumer price data have tended to surprise on the upside, and each time bond desks panic for a while. The economy has not suddenly caught fire. The cause is a persistent flaw in seasonal adjustment, which copes badly with the way companies set prices at the start of the year.

Where inflation stands

The December figures released this week set up the next test. Consumer prices rose by 3.4 per cent over the year to December, a little faster than in November, while core inflation, which strips out food and energy, slowed to 3.9 per cent. Shelter costs remain the largest single source of price pressure. Futures markets still price the first Federal Reserve rate cut for March, which means the January figures, due in mid-February, will be the last full consumer price report before that meeting.

That timing raises the stakes of a statistical quirk. A hot January reading would land just as traders are trying to decide whether the Fed can start easing, and it would carry more weight than it deserves.

New year, new prices

Many companies reset annual contracts in January, raising prices for software subscriptions and gym memberships, while medical fees and postal rates go up too. The Bureau of Labor Statistics tries to adjust for these calendar effects, but some seasonality slips through and pushes the January figure up. Sensible investors look past it, knowing the noise often fades by spring.

The reason some slips through lies in how the adjustment is estimated. Seasonal factors are calculated from the pattern of the previous several years, using statistical models that assume the calendar effect is stable. When inflation is low, a January price reset is small and the models capture it well. When inflation has been high, companies tend to raise list prices by more at the start of the year, often by reference to the previous year's inflation, and the models, anchored in calmer years, underestimate the seasonal jump. Social Security benefits also rise each January in line with the previous year's inflation, by 3.2 per cent this year, adding a modest boost to spending just as prices reset.

The pandemic made the problem worse

The years since 2020 have been especially hard for seasonal models. Lockdowns, reopening and the surge in goods prices in 2021 produced movements that the models partly mistook for seasonal patterns, and those errors feed into the factors applied today. Each February, when it publishes the January data, the bureau recalculates its seasonal factors and revises the adjusted figures for the previous five years. The revisions can shift where inflation appeared to be running in recent months, sometimes as much as the new data themselves.

What happened last year

January 2023 showed how this plays out. Consumer prices rose by half a percentage point in the month, and other January data, including payrolls and consumer spending, also came in strong. Bond yields jumped, and markets that had priced rate cuts for later in the year began to price a higher peak for the policy rate instead. The Fed's own officials talked of possibly raising rates by larger steps again. Within weeks the mood changed completely when Silicon Valley Bank failed, but the scare in February was driven in good part by the calendar.

Something similar tends to happen in other January data. Payroll figures are distorted by the seasonal release of holiday workers, and the personal consumption expenditures price index, the Fed's preferred measure, is affected by the same January price resets. Because the Fed often watches three- and six-month annualised rates of core inflation, one inflated January figure can distort those measures for half a year.

The case against dismissing it

The strongest counterargument is that not every January surprise is noise. In a year when inflation really is re-accelerating, a strong January reading can be the first honest signal, and dismissing it as seasonality would be a mistake. The bureau's annual revisions also reduce the problem over time, since each year of calmer data pulls the seasonal factors back towards normal. The seasonal pattern also differs across categories, so a hot January in rents or services would be harder to explain away than one in goods.

That argument is reasonable, but it points to a practical rule rather than a reason to panic. A January jump concentrated in items with known annual resets, such as insurance, medical services, subscriptions and some fees, should be discounted. A jump that is broad across categories, and that persists in February and March, deserves to be taken seriously.

Who is exposed to the scare

The traders most at risk are those holding short-dated Treasuries and interest-rate futures that assume a March cut. If January comes in hot, two-year yields could jump and March pricing could fade quickly, as it did last year. Rate-sensitive equities, such as housebuilders and small companies with floating-rate debt, would also sell off. Holders of inflation-linked bonds and investors positioned for a stronger dollar would gain for a while.

The costs of a false alarm are not only financial. If markets push up yields in response to a seasonal blip, mortgage rates and corporate borrowing costs rise too, tightening conditions for a few weeks without any change in underlying inflation. The Fed can look through such moves, but it cannot entirely ignore them.

What to watch

The details matter more than the headline. Investors should look at which categories drove any January jump, at the revised seasonal factors published alongside it and at whether services excluding housing accelerate or slow. The February and March reports will confirm or refute the signal. Comments by Fed officials after the release will show whether they share the market's alarm or look past it.

Another scare is likely when January's inflation figures arrive. It will say more about contract resets and seasonal adjustment than about price momentum, and the spring data will probably look calmer. The likely casualty is the market's bet on a March cut, which a hot January reading could knock back towards mid-year even if inflation continues to cool underneath.