December CPI: The Expectation Gap and What It Means for the Fed

The December CPI report delivered a clean beat on core expectations, but the headline print left the Fed's path largely unchanged. Core inflation rose just 0.2% month-over-month, undershooting the 0.3% consensus forecast. That's a meaningful miss. At the same time, headline CPI came in exactly at the 0.3% consensus forecast, matching expectations. This creates a nuanced picture: the core number was softer than feared, but the headline print was in line, offering no new signal of a sudden acceleration.

The immediate market implication is clear. The data supports the broad consensus that the Federal Reserve will hold rates steady at its meeting at the end of January. Analysts overwhelmingly expect the Fed to keep interest rates as-is, and this report fits that narrative. It shows inflation is still trending down, but the downward trend is slow and complicated by persistent shelter costs. The core undershoot provides a bit more ammunition for those betting on a dovish pivot, but it's not enough to reset the expectation that the Fed will wait for more evidence of a durable cooldown before cutting rates again.

The key takeaway is the expectation gap. The market had priced in a slightly hotter core print, perhaps due to lingering data distortions from last year's government shutdown. The report instead showed goods prices were very benign, with items like appliances and furniture falling in price. That benign goods picture suggests tariffs have had a muted impact on inflation, a story that supports the case for eventual cuts. Yet, with annual inflation still at 2.7% and shelter costs a persistent driver, the Fed is likely to remain cautious. The clean beat on core was a relief, but the headline in-line print means the Fed's path remains on hold.

The Drivers: Shelter's Dominance and Goods' Benignity

The expectation gap in December's CPI report is driven by a clear split in price pressures. On one side, shelter costs are proving stubbornly sticky, while on the other, goods prices are showing remarkable benignity. This mixed picture is the core reason why the disinflation trend remains slow and uncertain.

Shelter, the largest driver of the overall index, rose 0.4% for the month. That's a significant uptick from the 0.2% seen in November and is the single biggest contributor to the headline 0.3% monthly gain. This persistent housing inflation is a key reason why the annual rate for all items is stuck at 2.7%. It signals that the lagged impact of past rent increases is still working through the system, providing a clear headwind to a faster cooldown.

At the same time, the goods sector is delivering a powerful counter-narrative. The index for all items less food and energy rose just 0.2%, and the broader commodities index actually fell 0.2% for the month. Specific categories like used cars and trucks and household furnishings and operations saw notable declines. This benign goods picture suggests the transmission of recent tariff costs to consumer prices has been muted, as some retailers absorbed the hit rather than passing it on. It's a sign that the peak in goods inflation may have passed.

The most acute pain point for consumers, however, is food. The index surged 0.7% for the month, with the annual rate hitting 3.1%. This acceleration from November is a direct hit to household budgets and complicates the story of broad disinflation. It shows that while some categories are cooling, others are not, creating a patchwork of price pressures.

The implication for the Fed is a classic case of "expectation reset." The market had priced in a slightly hotter core print, but the data showed shelter's dominance and goods' weakness. Yet, with food prices surging and shelter still sticky, the disinflation story is not accelerating. It's progressing slowly, which means the Fed is likely to maintain its wait-and-see stance. The expectation gap here is not about a single number missing a forecast, but about the sustainability of the trend. The mixed drivers suggest the path to 2% is long and bumpy, not a straight line.

The Fed's Path: Guidance Reset or Hold Pattern?

The December CPI data has reset the immediate expectation gap, but it hasn't changed the Fed's likely course. The report supports the overwhelming market consensus that the central bank will hold rates steady at its meeting at the end of January. Analysts expect the Fed to keep interest rates as-is, and the data fits that narrative. The core undershoot provides a reason to pause, but the Fed is likely waiting for clearer evidence of sustained disinflation before cutting.

The mechanism for this caution is twofold. First, there are lingering data distortions from last fall's government shutdown, which clouded the shelter price picture. As Vanguard's Josh Hirt notes, the Fed won't have enough evidence to cut rates at its meeting in a few weeks. Second, the mixed drivers create a "slow and bumpy" path. While goods prices are benign and core inflation softened, shelter costs are sticky and food prices surged. This patchwork means the disinflation trend is not accelerating, which keeps the Fed cautious.

The next major data point is the January PCE, but the March meeting is now the likely window for a policy shift. The Fed is essentially on hold, using the January meeting to gather more data and confirm the slow, uneven cooldown. The expectation gap here is about the timing of the pivot, not the decision itself. The market had priced in a slightly hotter core print, but the data showed a complex reality. That reality-sticky shelter, surging food, and artificially low goods due to holiday discounts-means the Fed needs more months of clean prints to feel confident in a sustained move toward its 2% target.

The bottom line is a guidance reset for the forward view, not a policy reset. The Fed is signaling it will wait for more durable evidence before cutting, even as it acknowledges inflation is trending down. For now, the hold pattern is priced in.

Catalysts and Risks: What to Watch in 2026

The expectation gap for 2026 hinges on two key forces: the stubbornness of shelter costs and the stability of consumer psychology. The primary risk is that shelter inflation proves stickier than the slow, bumpy path the Fed is currently on. As evidence shows, shelter prices drove December inflation, with rent and housing costs seeing the largest monthly increase. Vanguard economist Josh Hirt notes this is due to a low supply of single-family homes and a lack of softening in housing prices despite higher rates. If this trend persists, it could anchor core inflation above the Fed's 2% target, preventing the disinflation story from accelerating.

The mechanism is clear. Shelter costs are a lagged indicator, meaning past rent hikes continue to feed through the system. If they remain elevated, they will keep the annual core rate from falling to target, forcing the Fed to maintain its wait-and-see stance. This creates a feedback loop where persistent price pressures could harden inflation expectations, making them self-fulfilling.

A key catalyst for closing the gap is the March FOMC meeting. That gathering is now the likely window for a policy shift if disinflation continues. The Fed needs more months of clean prints to confirm the slow cooldown is durable. The expectation is that the central bank will begin to signal a shift in its guidance at that meeting, but only if the data supports it.

Equally important is the trajectory of consumer inflation expectations. These recently rose to 3.4% in the New York Fed survey, a concerning uptick. If consumers believe inflation will stay high, they may demand higher wages or change spending habits, which could feed back into price pressures. This is a classic expectation trap: elevated expectations can become a self-fulfilling prophecy, complicating the Fed's task.

The bottom line for 2026 is a tug-of-war between these forces. The Fed's path is set to hold, but the March meeting will be the litmus test. The risk is that shelter costs keep the core rate elevated, while the catalyst is a sustained disinflation trend that finally convinces the central bank to pivot. Watch for any shift in consumer expectations, as that could be the first sign of a broader psychological reset.