(Bloomberg) -- The Federal Reserve is on track to downshift to smaller interest-rate increases following a further cooling in US inflation, though it’s likely to keep hiking until price pressures show more definitive signs of slowing.

Philadelphia Fed President Patrick Harker, speaking Thursday morning shortly after the Labor Department’s release of consumer price data, said rate hikes of a quarter-percentage point “will be appropriate going forward,” following bigger increases throughout most of 2022. Harker’s comments echoed remarks a day earlier from Susan Collins, his counterpart at the Boston Fed.

Consumer prices rose 6.5% in the 12 months through December, marking the slowest inflation rate in more than a year. So-called core inflation, which excludes food and energy, was up 5.7% over the same period, the smallest advance in a year. Both figures matched median forecasts.

“The trend in services inflation seems to be abating. That’s what the Fed will be looking at in today’s report,” said Thomas Costerg, a senior US economist at Pictet Wealth Management in Geneva, Switzerland. “At the margin, this means an increased probability of a 25-basis-point rate hike on February 1st.”

Investors seized on the numbers as a sign that the Fed would dial down the pace of its tightening campaign, which ramped into high gear last year amid the fastest inflation in four decades.

The message of moderation was later reinforced by Richmond Fed President Thomas Barkin, who told a bankers conference that “it makes sense to steer more deliberately as we work to bring inflation down.” On the other hand, his St. Louis colleague James Bullard separately said that he continued to favor front-loading policy moves to get rates above 5% “as soon as possible.”

Harker is the only voter this year on monetary policy among the four officials who spoke publicly on Thursday.

With the central bank’s benchmark rate now at 4.3%, market participants expect a quarter-point rate hike at the Jan. 31-Feb. 1 meeting. And traders have also started to price in a small possibility that the Fed will forego a rate hike in March. Swaps shifted to show less than 50 basis points of tightening priced in across the next two meetings.

While moderating inflation paves the way for a slower pace of rate increases in 2023, the market’s expectation of rate cuts later in the year is still at odds with Fed guidance. Policymakers have emphasized the need to hold rates at an elevated level for quite some time and cautioned against underestimating their will to do so.

The outlook for interest rates probably hinges on developments in services prices in particular, a category Fed Chair Jerome Powell and his colleagues have homed in on in recent months. Officials have voiced concern that elevated wage growth will feed into prices in the services sector, keeping inflation there elevated until the labor market softens.

So far, there are few signs of such weakness. A separate Labor Department report Thursday showed applications for unemployment benefits remained at a historically-low level last week. The latest monthly jobs report showed some cooling in wage growth in December, but hiring was still robust and the unemployment rate fell to match a five-decade low.

Stripping out energy, rent and owners’ equivalent rent, services prices were up 0.3% last month, according to Bloomberg calculations. Removing medical care as well — an adjustment that helps offset a quirk in the CPI’s calculation of health insurance — services prices were up by a similar amount.

What Bloomberg Economics Says...

“A mostly favorable December CPI report gives the Fed room to further downshift the pace of rate hikes to 25 basis points at the Jan. 31-Feb. 1 meeting. We expect the Fed funds rate to peak at 5% in March and stay at that level for the rest of the year.”

—Anna Wong, economist

To read the full note, click here

Shelter costs — which are the biggest services component and make up about a third of the overall CPI index — increased 0.8% last month, an acceleration from November. Rents and owners’ equivalent rent both rose by the same amount, while hotel stays advanced 1.5% after falling in the prior month.

Because of the way this category is calculated, there’s a delay between real-time measures — which currently show rents are beginning to decline — and the Labor Department data. 

Excluding food and energy, goods prices fell 0.3%, led by used cars. Gasoline prices dropped 9.4%, “by far” the largest contributor to the decrease in the headline figure, the Labor Department said.

A rotation in spending from goods to services continues to weigh on merchandise prices. A further retreat in goods prices is expected to be a major driver of a rapid descent in annual core CPI in 2023, building on a pullback in the final months of last year.

While it’s broadly expected for annual price growth to substantially slow this year, a lot of uncertainty remains as to how far inflation may fall and whether the Fed’s rapid rate increases ultimately tip the US into recession.

Some Fed watchers cautioned that the coast is not yet clear for a downshift to quarter-point hikes, even despite the good news on inflation.

“The base case for the February meeting is 25 basis points, but with still notable risk of 50 basis points,” said Roberto Perli, the head of global policy research at Piper Sandler & Co. in Washington. “What matters the most is the peak rate, and there is no reason to believe that the Fed changed its mind about it being north of 5% based on today’s report.”

--With assistance from Chris Middleton, Sydney Maki, Jordan Yadoo, Steve Matthews and Craig Torres.

(Upates with comments from Bullard and Barkin in sixth paragraph.)

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