December CPI: The Market's "Priced In" Expectation Gap

The December CPI report delivered a classic expectation gap. The headline number was a clean match for the market's forecast, with the overall Consumer Price Index rising 2.7% annually and 0.3% monthly. That alignment met the consensus, but the real story was in the details. The core CPI, the gauge the Fed watches most closely, came in at 2.6% annually and 0.2% monthly. That monthly figure was a full 0.1 percentage point below the 0.3% forecast from economists.

This is the essence of a "beat and hold" setup. The headline met expectations, but the core inflation print missed. For the market, that small miss was enough to dampen immediate hopes for a rate cut. It reinforces the view that inflation, while easing, remains stubbornly above the Fed's 2% target. The core CPI's failure to accelerate, despite a 0.3% monthly jump in the headline, signals that underlying price pressures are not yet cooling as quickly as needed to justify a January move. The market's priced-in expectation for a cut in January now looks increasingly fragile.

The Drivers: Where Inflation Persisted and Where It Was Held Back

The December CPI miss on core inflation was not a broad-based slowdown. It was a story of specific categories pulling the average in different directions. The monthly core print of 0.2% was a clear beat against the 0.3% whisper number, but the drivers reveal a complex picture of persistent pressures and temporary offsets.

On the pressure side, shelter and food were the primary engines. Shelter costs rose 0.4% over the month, a typical seasonal uptick but still a key contributor to the annual core rate holding at 2.6%. More notably, food prices jumped 0.7%, marking the largest monthly gain in years. This surge in groceries is a direct hit to household budgets and a clear sign that underlying price pressures remain elevated in essential goods.

Yet, other categories acted as a significant brake. Auto prices provided a notable offset, with used-car prices dropping 1.1% on the month and new vehicle prices flat. This helped hold down the core print. Similarly, household furnishings declined, further contributing to the deceleration.

The most telling red flags, however, point to longer-term cost-of-living strains. Recreation prices saw a record surge of 1.2% monthly, while home insurance costs climbed 1% on the month and 8.2% over 12 months. These are not fleeting spikes; they represent sustained increases in discretionary spending and a major component of housing expenses that are likely to persist.

The bottom line is that the core miss was a statistical artifact of these conflicting forces. The market was expecting a more uniform monthly acceleration, but the data showed shelter and food pushing up the headline while autos and furnishings pulled down the core. For assessing sustainability, the record home insurance gains and the recreation price surge are more concerning than the temporary auto price relief. They suggest that the disinflationary trend is uneven and that certain pockets of consumer spending remain under significant pressure.

The Market's Reaction: What Was Already Priced In

The muted market reaction to the core CPI miss is the clearest signal that the data was already priced in. Traders didn't need a surprise to adjust their bets; they had been expecting a hold for weeks. The initial, brief moves in stocks and Treasuries were a classic "buy the rumor, sell the news" dynamic. The report confirmed the status quo, removing a near-term catalyst for action and allowing the market to reset its forward view.

The key takeaway is that the expectation gap was not about the direction of rates, but about the timing. The market had already discounted a January Fed pause. Evidence shows traders kept their bets intact, with the CME Group's FedWatch gauge indicating the Fed would stand pat at its meeting later this month and likely won't be considering another cut until June. This forward guidance is the real story. The core miss didn't change the narrative; it validated it. It provided the "convincing sign" that inflation is on a downward path, reinforcing the view that the Fed's next move is a long way off.

For assets, this means the focus shifts from a potential January cut to the next potential catalyst. The report's main impact was to confirm the hold scenario, which is why Treasury yields initially rose on the miss but then faded. The market had already priced in the risk of a hold, so the miss didn't trigger a sustained repricing. Instead, it solidified the path to a June cut, which is now the new baseline expectation. The muted reaction confirms that the expectation gap was closed, leaving the market to look ahead to the next data point that could finally move the needle.

Catalysts and Risks: What to Watch in 2026

The expectation gap for 2026 hinges on two key factors: a potential statistical distortion and the re-acceleration of the largest inflation driver. The market's priced-in view of a June cut could be derailed by either.

The first risk is a false signal from the data itself. The Bureau of Labor Statistics' method for handling the October-to-December shutdown disruption could impart a downward bias on the CPI inflation data through April. This means the current cooling trend might be partly an artifact of how the BLS filled in missing months. If this carry-forward effect fades, the underlying inflation rate could snap back higher, widening the gap between the market's optimistic forward view and reality.

The second, more fundamental risk is a sustained acceleration in shelter costs. Shelter remains the single largest component of the CPI, and its monthly rise of 0.4% in December was the biggest factor in the headline print. While the core index was held back by other categories, persistent shelter inflation is the primary engine that could reignite the broader trend. Watch for this to become a more consistent, less offsetting force.

The next major catalyst is the January FOMC meeting. The Fed's guidance on the timing of its first cut will be the primary focus. Traders are already pricing in a hold, with the CME Group's FedWatch gauge showing the market expects the Fed to stand pat at its meeting later this month and likely won't be considering another cut until June. The central bank's language on inflation and its path to 2% will determine if that timeline holds or gets reset.

In short, the setup is one of fragile equilibrium. The market has priced in a hold and a June cut, but that view is vulnerable to a data distortion fading or shelter costs re-accelerating. The January meeting will test the durability of that priced-in expectation. Watch for any shift in the Fed's forward guidance, as that will be the clearest signal of whether the expectation gap is closing or opening wider.