Stock and bond markets dropped sharply this morning on an unexpectedly high reading for the US Consumer Price Index in January. Headline CPI rose by 0.5% and core CPI (minus food and energy) by 0.3%. At 8:50 am, US Dow Jones Industrial Index futures had fallen by 238 points and the 30-year US Treasury bond lost 12/32nds.

The dogs that didn’t bark were the US dollar, virtually unchanged after the number, and the real (inflation-adjusted) US 10-year yield, which is slightly down. The inflation component of the 10-year yield rose by about 4 basis points, a very measured response. But the real yield is the important one for the US economy, and also the most important gauge of market expectations about central bank policy.

If the market believed that the CPI surprise represented a trend rather than a blip, it would bid up real yields, expecting the Federal Reserve to raise interest rates in the future (expectations about the future federal funds rate are the big near-term determinant of real yields).

10-yr TIPS
Source: Bloomberg

As the intraday chart above makes clear, that was the market’s first response to the CPI number: the 10-year TIPS yield jumped from 0.76 to 0.80 in the first 10 minutes after the number appeared. Then it fell back to exactly where it had been before the announcement. Presumably bond traders looked at the same numbers that Asia Unhedged looked at, and concluded that the price fluctuations of clothing during after-Christmas sales would not determine the policy of the world’s most important central bank.

The single biggest contributor to the unexpectedly high increase in the Core CPI (0.3% vs. an expected 0.2%) was a big jump in the price of apparel. Without apparel, the core reading would have been just 2.4% rather than 3%. Given that apparel prices change massively between December and January due to post-Christmas discounting, the entire difference may be a result of seasonal adjustment issues. The rate of price change for the most important item in the core CPI basket, shelter, was actually slightly lower in January than December. As noted, apparel explains 6/10ths of the difference between the actual and predicted core CPI number. The rest of it is explained by motor vehicle insurance and physicians’ services.

Relative contribution to CPI change
Source: Bloomberg

In short, the report should not be taken too seriously. In a globalized world, with massive overcapacity in the garment industry, and vast changes in online retailing for clothing, and tectonic shifts in consumer preferences towards cheaper generic brands rather than expensive labels–it is hard to swallow the idea that the fate of the US economy hangs on the Bureau of Labor Statistics’ measurement of apparel prices over the past Christmas season.