Inflation just dropped to 6.5%—but the 'most important' factor in predicting if it will keep falling is up 0.4%

Federal Reserve Board Chairman Jerome Powell speaks during a news conference on December 14, 2022 in Washington, DC.
Alex Wong | Getty

The rate of inflation declined for the sixth straight month, dropping to a year-over-year rate of 6.5%, according to the latest Labor Bureau data released Thursday.

However, an inflation measure recently described by Federal Reserve Chairman Jerome Powell as "most important" in determining where inflation will go has increased after being largely flat for the previous two months.

The Fed has said it's closely watching the cost of services excluding shelter, which is a category in the consumer price index, or CPI, a monthly report that measures the cost of goods and services commonly used by Americans.

In Thursday's CPI report, "services less rent of shelter" showed a 0.4% increase in December. In November, the category remained flat at 0%. In summer 2022, at the height of inflation, increases were closer to 1%.

The category — which covers a wide range of services including haircuts, education and hospitality — is the "key" bellwether for where inflation is headed, Powell explained in a late November speech.

Prior to today's CPI report, the costs of services excluding housing had shown "tentative signs of rebalancing," according to Powell.

However, since wages are "the largest cost in delivering these services," he said, that might indicate out-of-control wage growth, which is currently above levels that correspond with the Fed's benchmark target of 2%. Powell previously cited high wage growth as one of the reasons inflation might remain elevated.

With "services less rent of shelter" increasing in December, rising inflation will likely remain a concern for the central bank.

And despite the drop in year-over-year inflation, it's probably too early to say that inflation is under control, especially with it still well above the Fed's target of 2%, said Greg McBride, chief financial analyst at Bankrate.

"To truly feel as if we've hit peak inflation, we've got to see sustained improvement over a period of months, and across an expanding range of goods and services," he said.

Still, other measures seem to be trending in the right direction, according to Powell's recent comments. While "far from vanquished," price growth for goods — things you buy, such as laundry detergent or cars — has been declining over the past year, said Powell.

This is reflected in consumer prices dropping by 0.1% last month. Gas prices have been dropping as well, with a whopping 9.4% decline in December alone.

Similarly, the rising cost of homes and rent is also expected to decrease in the back half of 2023, according to Powell.

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