December Inflation: The Data Distortion That Could End the Fed's Cuts

The December inflation print presents a classic puzzle for policymakers. The annual core CPI figure landed at 2.7%, the lowest level since early 2021. On the surface, that looks like a clean victory for the disinflation narrative. Yet the story told by the monthly data is far more complicated. Core CPI rose 0.3% on a month-over-month basis, a clear reversal from the downward pressure seen earlier in the year and driven primarily by higher goods prices. This creates a tension: a durable low annual rate versus a sticky monthly uptick.

The core question is whether this stabilization is real or a statistical artifact. The answer hinges on a critical, unresolved distortion: the government shutdown that prevented the Bureau of Labor Statistics from collecting data for October. As a result, the November monthly figure was not published, and the December report must bridge a significant data gap. The BLS itself has noted that distortions linked to the shutdown may still be affecting the figures. To fill the void, agencies like the Cleveland Fed have relied on inflation nowcasts for October, which are estimates based on other economic indicators. While these models are sophisticated, they introduce a layer of uncertainty about the true trajectory of prices over that critical period.

Viewed another way, the December print may simply reflect a return to a more normal, albeit still low, inflation range. The 0.3% monthly jump, while notable, is not explosive. The broader context shows a year-over-year core rate that has been trending down for months. The real damage, however, is to credibility. When a key data point is missing and must be estimated, it weakens the statistical foundation for any policy decision. For the Federal Reserve, this undermines the case for further rate cuts. The data needed to confirm a durable, sustainable disinflation trend are now clouded, making it harder to argue that inflation is definitively under control. The stabilization near target is plausible, but its quality is in question.

The Fed's Calculus: Data Quality vs. Policy Momentum

The Federal Reserve now faces a classic dilemma: a policy path set by momentum, but a data foundation that is itself in question. The tension is stark. On one side, internal hawkishness on inflation persists. Atlanta Fed President Raphael Bostic, in a December message, stated that price stability remains the "most pressing risk" facing the FOMC. His view is grounded in the reality that the underlying price level has risen by about 20% over five years, a burden that continues to weigh on households. Yet, even as he voices this caution, the Fed has already acted, cutting rates by 25 basis points in December. This decision itself reflects a collective judgment that risks to the labor market outweigh risks to price stability, a trade-off that defines the current quandary.

On the other side of the table, market expectations are firmly dovish. The minutes from the December meeting show that investors' outlooks were little changed, but their implied path was clear. The "modal outlook from the survey as well as from options pricing implied two additional rate cuts next year." This market consensus, which priced in a total of three cuts for 2026 following the December move, creates a powerful external pressure. It suggests a belief that the disinflation trend is durable enough to support further easing, regardless of the data's statistical quirks.

This sets up a complex calculus. The Fed must navigate not only the quality of the inflation data but also two major structural overhangs. First is the ongoing balance sheet runoff, a policy that continues to drain liquidity from the financial system, a subtle but persistent headwind to growth. Second is the looming political transition. Chairman Jay Powell's term expires in May 2026, and the appointment of a new leader introduces a layer of uncertainty. As one analysis notes, a potential new chair may result in some uncertainty, which could influence the pace and direction of policy in the coming months.

The bottom line is a policy path that is more certain than the data justifying it. The Fed has cut, and the market expects more cuts. But the internal debate, as exemplified by Bostic's caution, reveals a committee that is not uniformly convinced the inflation battle is won. The December inflation print, with its statistical distortion, makes that internal division harder to resolve. The momentum for easing is strong, but it is now being weighed against a less clear picture of price stability-a tension that will define the Fed's first major decisions of 2026.

Market Metrics and Catalysts: Reading the Yield Curve

The bond market is now pricing in a clear but cautious path. The most likely scenario for 2026, as outlined by portfolio strategists, is a gradual reduction in rates from the current 3.50% to 3.75% range to closer to 3%. This trajectory hinges entirely on the Fed receiving clearer signals from inflation data. The current setup-a stabilization of core inflation near target-favors a "higher for longer" environment. In practice, this means the yield curve will likely flatten, with shorter-duration bonds offering better value as investors manage interest rate risk.

The primary risk to this outlook is that the data distortions from the government shutdown are masking a deeper, more persistent inflationary trend. If subsequent reports reveal that the recent uptick is not a statistical blip but the start of a new phase, the Fed's easing cycle could be forced to pause or even reverse. This would break the "no more cuts" thesis and likely push yields higher across the curve, particularly in the intermediate and long maturities.

Investors must watch two key catalysts. First is the next official CPI report, due in February. It will be the first full data point since the October gap, offering a critical test of whether the December monthly rise was an anomaly or the beginning of a new trend. Second is the Fed's balance sheet runoff schedule. The ongoing reduction of its holdings continues to drain liquidity, a subtle but persistent upward pressure on rates that could counteract the Fed's own easing moves.

The bottom line for the yield curve is one of managed expectations. The market has priced in a total of three rate cuts for 2026 following the December move. But with the data foundation now questioned, the path will be bumpy. The most prudent strategy is to position for a gradual decline, focusing on the belly of the curve for yield and liquidity, while remaining alert for any data that could confirm the inflationary risks are still present.