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Economic and Market Commentary

Inflation Headache Remains for the Fed

The latest inflation report raises the odds of further Federal Reserve action.

Another firmer-than-expected CPI (Consumer Price Index) report raises the chances the U.S. Federal Reserve will hike interest rates one more time this year.

Core U.S. CPI rose 0.3% in September compared with August, firmer than our 0.2% expectation, while headline inflation rose 0.4% from August. Higher costs for housing and hotels drove much of the upside surprise.

Most concerning is the reacceleration in core, wage-sensitive services categories over recent months. While one should never read too much into any one data print, the September report underscores our skepticism of the Fed’s expectation of an economic soft landing. Indeed, we’ve argued that labor markets need to weaken, including a rise in the unemployment rate, for inflation to more fully moderate back to the Fed’s 2% inflation target.

Implications for near-term Fed policy are complicated. While this report and the recent strong payroll report argue in favor of another interest rate hike before year-end – as the majority of Fed officials projected in the September Summary of Economic Projections (SEP) – tighter financial conditions (if sustained) are doing much of the work for them.

Devil in the details

Most of the upside surprise in CPI relative to our expectations was in the volatile travel services categories. Hotel prices rebounded from weakness over the past few months, rising 4.2% over August, adding 5 basis points (bps) to core CPI. However, owners’ equivalent rent (OER) was also unusually volatile, rising 0.56% from August, compared to 0.38% in August versus July.

Prices for shelter are now 7.15% higher than a year ago, still far from the pre-pandemic trend of 3.0% to 3.5%. Nevertheless, judging from new tenant lease rents and other measures of “market rents,” there appears to be a good amount of disinflation in the pipeline.

Not all higher

The one bright spot of the report is deflation in core goods, which fell 0.4% compared with August. Once again, the big driver was used car prices, which fell by 2.5%, clipping 9 bps from core CPI in September.

More recent wholesale used car pricing data from Manheim suggest the rapid drop over the past few months is starting to bottom and will not continue to support lower core inflation to the same extent. However, that may be somewhat offset by faster deflation in the retail goods categories. We’ve been expecting retail goods prices to moderate as lower cotton prices moderate inflation in clothing, a weaker yuan lowers prices of Chinese imports, and consumers become increasingly price sensitive after bingeing on consumer goods over the last several years. Prices for core goods are now 0.03% below those of a year ago – the first core goods deflation since 2020 and a remarkable disinflationary path after peaking above 12%.

Pressure on the Fed

Overall, the latest CPI data are likely to create some anxiety for Fed officials. While core goods deflation is helping reduce overall inflation, the lack of progress across wage-sensitive services categories underscores our view that more labor market weakness will be needed to bring inflation back to mandate-consistent levels. We’ve been skeptical that the Fed would actually deliver the additional hike projected by the majority of Fed officials, but at this point we are leaning toward them getting it in despite the recent tightening in financial conditions. It’s a very close call.

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