Questionable U.S. Inflation Data and Its Implications for Fed Policy and Market Positioning

The reliability of U.S. inflation data has come under intense scrutiny in 2025, with methodological flaws in the Consumer Price Index (CPI) casting doubt on the accuracy of reported disinflation trends. These distortions, exacerbated by a 43-day federal government shutdown and flawed imputation techniques, have created a "data gap" that risks misinforming Federal Reserve policy and market strategies. As the Fed grapples with whether to cut interest rates and investors adjust positioning in Treasury Inflation-Protected Securities (TIPS) and equity sectors, the stakes of these methodological issues have never been higher.

Methodological Flaws and CPI Distortions

The Bureau of Labor Statistics (BLS) faced unprecedented challenges in 2025, including the suspension of data collection during the October–November government shutdown. To fill gaps, the BLS resorted to carrying forward prices from September 2025 into October and November, a method that assumes zero inflation in critical categories like owners' equivalent rent (OER). OER alone accounts for 26% of the CPI basket, and its reported plunge in September-a "suspicious outlier"-was mechanically extended into subsequent months, creating a downward bias in inflation readings according to analysis. This approach ignored real-world trends, such as resilient private-sector rent data, which suggested higher inflation persistence.

The impact was particularly pronounced in housing, a key driver of core services inflation. Economists warned that the November 2025 CPI report, which showed a sharp slowdown in shelter inflation, likely underrepresented true inflationary pressures. For example, the BLS's use of a six-month lag in OER calculations further distorted the data, as it averaged rent changes over a period that excluded recent spikes. These flaws were compounded by delayed data collection in goods categories, where holiday discounting skewed year-over-year comparisons.

Fed Policy and the Risk of Misaligned Rate Cuts

The Federal Reserve's reliance on CPI data to guide monetary policy has been thrown into question. In late 2025, the Fed faced a dilemma: while the November CPI suggested disinflation, core PCE (a preferred Fed metric) and private-sector data hinted at persistent inflation. This divergence forced the Fed to navigate a "policy error" risk, as flawed CPI readings could lead to premature rate cuts or insufficient responses to inflationary pressures.

For instance, the March 2025 FOMC meeting saw officials hold rates steady at 4.5% despite mixed signals, citing uncertainty about the economic outlook and the inflationary impact of tariffs. By September 2025, concerns over tariff-driven inflation and the risk of de-anchoring long-term inflation expectations led the Fed to delay rate cuts, even as CPI data appeared to show progress. Market-implied probabilities for a December 2025 rate cut hovered around 65%, but Fed officials remained cautious, emphasizing the need for "more reliable, normal reporting" before acting.

Market Positioning: TIPS Demand and Sector Rotations

Investors have responded to CPI uncertainties by recalibrating their strategies. TIPS ETFs, such as the iShares TIPS Bond ETF (TIP) and Vanguard Short-Term Inflation-Protected Securities ETF (VTIP), saw significant inflows in late 2024 and early 2025 as investors hedged against inflation risks. This trend was driven by expectations of a "hotter-than-expected" CPI report, which historically correlates with underperformance in equities. For example, TIPS prices surged ahead of the November 2025 CPI release, reflecting market skepticism about the data's accuracy.

Equity sector rotations also shifted in response to CPI distortions. Large-cap growth stocks, particularly in the communication services sector, outperformed the S&P 500 by 33.6% in 2025, partly due to their exposure to AI and digital media. Conversely, energy and industrials were underweighted as investors sought sectors less sensitive to inflationary pressures. Midyear, utilities were also underweighted, a decision that proved costly as AI-driven power demand drove the sector to outperform. These rotations highlight how CPI-related uncertainties have reshaped asset allocation, with investors prioritizing growth and defensive sectors over cyclical ones.

Quantitative Impacts and Policy Risks

The December 2025 CPI report, expected in January 2026, will be critical in determining whether the observed disinflation is genuine or an artifact of methodological flaws. If the data continues to show a sharp slowdown in inflation, the Fed may feel pressured to cut rates, even if underlying trends suggest otherwise. This could lead to a "self-reinforcing cycle" of rate cuts and inflation persistence, as seen in the 2023 banking crisis, where aggressive rate hikes exacerbated financial instability.

For markets, the implications are equally significant. If the Fed misinterprets CPI data and cuts rates prematurely, it could trigger a surge in risk assets and a sell-off in TIPS, as investors reassess inflation expectations. Conversely, if the Fed overcorrects by maintaining high rates in response to flawed data, it could stifle economic growth and trigger a market selloff.

Conclusion

The methodological flaws in U.S. CPI data have created a "perfect storm" of uncertainty for both policymakers and investors. While the Fed has shown caution in its rate-cut decisions, the December 2025 CPI report will be a pivotal test of its ability to navigate these challenges. For investors, the lesson is clear: positioning strategies must account for the possibility of distorted inflation data, with a focus on inflation-linked instruments and sectors less vulnerable to policy missteps. As one economist put it, "The CPI is not a mirror-it's a funhouse mirror," and interpreting it requires a healthy dose of skepticism.