October’s U.S. Consumer Price Index (CPI) data came in hotter than consensus expectations, delivering another disappointing inflation report for a Federal Reserve that has become increasingly vocal about its focus on price stability. Together with Fed Governor Christopher Waller’s comments earlier in the day, the report strengthens the case for another rate hike at the Fed’s December meeting and raises the possibility of a larger 50-basis-point (bp) move.
Our baseline is not yet a 50-bp hike in December. However, we are shifting our forecast to include 25-bp hikes in both December and January, with some risk of another hike in March. If Fed Vice Chair John Williams and Fed Governor Philip Jefferson reinforce Waller’s message in their upcoming comments, that could be enough to shift our December forecast to a 50-bp hike.
Even so, we would characterize the Fed’s current tightening less as the beginning of a new hiking cycle and more as a recalibration of policy aimed at preventing financial conditions from easing in a way that results in a broadening out of inflation from what should have been temporary inflation shocks.
Notable trends in the inflation data
After an uncomfortably firm September reading, inflation was again stronger than the Fed would have liked in October. Core CPI, which excludes the more volatile food and energy categories, rose 0.33% on the month, with firmness relatively broad-based across categories.
Part of that strength continues to reflect higher input costs from energy, chips, tariffs, and shipping being passed through to consumers.
Higher global crude oil prices and stronger refining margins have sharply increased the cost of refined products, including gasoline, diesel, and jet fuel. We estimate that these higher costs are also being passed through indirectly via price increases across retail goods categories and transportation-related services. Altogether, this channel could add roughly 50–60 bps to the year-over-year rate of core inflation this year.
Iran-related shipping disruptions could amplify these pressures. Higher freight and diesel costs, along with shipping delays, have left some retailers with lower-than-normal inventories ahead of the holiday shopping season, according to corporate earnings commentaries.
The good news is that much of this adjustment should already be behind us. Assuming energy prices broadly follow current futures curves, we estimate roughly 70%–80% of the anticipated pass-through has already occurred.
October’s CPI report, however, was not simply an energy story.
Categories that should be less directly affected by these cost pressures, including shelter, recreation, and other non-transportation services, were also firm. These categories tend to be more closely associated with domestic labor market conditions, wages, and underlying inflation, making their strength in October more notable.
So far, labor market fundamentals remain relatively benign. Wage-cost pressures have not reaccelerated in a way that resembles 2021 or 2022. Higher energy, freight, tariff, and chip costs can temporarily raise price levels and year-over-year inflation. The more concerning outcome would be for those first-round price increases to feed into wages, services inflation, inflation expectations, and broader pricing behavior.
We do not yet see convincing evidence that this is happening.
The next few inflation reports could remain uncomfortable
Even as some of the original supply pressures begin to fade, the next several CPI reports could remain firm as past cost increases continue to work through retail prices.
Holiday discounting is one area we are watching closely. Retailers typically discount goods aggressively during the holiday shopping season to drive volumes. This year, however, Iran-related shipping disruptions are raising freight costs, on top of higher diesel prices, while constraining inventories in some categories. Retailers may therefore have less incentive or ability to discount as aggressively as usual.
Because holiday discounting itself is seasonal, smaller-than-usual discounts could mechanically boost seasonally adjusted goods inflation even without another increase in underlying input costs, although the reverse would happen in January and February when lower holiday prices usually revert after the holidays.
This creates the possibility that inflation data remain firm over the next few months even as oil prices and some of the original cost pressures are already reversing.
Implications for Fed policy: watching financial conditions
October’s inflation report strengthens the case for additional Fed tightening, but we still see the current episode as a policy recalibration rather than the start of another prolonged hiking cycle. Based on the CPI data, we estimate core PCE rose roughly 0.36% (month-over-month) in October, lifting the year-over-year rate to around 3.3%. That is uncomfortably high, but still well below the inflation rates reached in 2022.
Policy is also starting from a very different place. The current 3.75%–4.0% fed funds range is roughly 100 bps below our estimated Taylor-rule rate, compared with a gap of around 800 bps in early 2022 (see Figure 1). After several months of firmer inflation, the Fed will likely want to narrow that gap, particularly given the risk of allowing what may be a temporary inflation shock to become more persistent.
Figure 1: The gap between the Fed policy rate and Taylor-rule prescriptions is narrower in 2026 than in 2022
For illustrative purposes only
Source: Federal Reserve Monetary Policy Report (July 2026), Federal Reserve Bank of San Francisco, and PIMCO calculations as of October 2026, with estimates through December 2027
How much additional tightening is needed will depend on financial conditions. Higher rates across the yield curve, along with more recent weakness in credit and equity markets, are already doing some of the Fed’s work. The San Francisco Fed proxy funds rate (see Figure 1 above), which incorporates broader financial conditions, suggests the effective stance of policy is closer to Taylor-rule prescriptions than the fed funds rate alone would imply.
The Fed therefore needs to maintain restrictive financial conditions, but it does not necessarily need a dramatically higher policy rate to achieve that outcome. If equities rally, credit spreads tighten, and longer-term yields fall while inflation remains firm, the Fed will likely need to hike more. If financial conditions tighten further, markets can do more of the work.
This framework reconciles our expectation for additional hikes with our forecast for substantially lower inflation next year. The Fed can tighten now precisely because it wants to make sure a temporary inflation shock stays temporary.
Demand should moderate as buffers fade
U.S. final domestic demand has remained surprisingly resilient despite this year’s supply shocks. AI-related capital spending has supported investment, although its high import content limits the contribution to U.S. real GDP growth (for details, see the 15 October 2026 Macro Signposts). Consumption has also remained solid, as tax cuts and wealth gains have helped cushion households from higher energy prices and given firms more room to pass higher costs through to consumers.
Those supports should fade. Equity market performance has stalled, the retroactive tax cuts in the One Big Beautiful Bill Act provided more of a one-time boost, and higher rates and tighter credit conditions should increasingly weigh on activity. In effect, this year’s supply shock hit an economy that had enough demand resilience to absorb it, but that backdrop should become less supportive over the coming quarters.
Bottom line
Our baseline remains that U.S. inflation falls materially in 2027 as the energy shock fades, financial conditions remain restrictive, and demand moderates. The recent decline in oil prices reinforces that view. The Fed’s challenge is to prevent today’s largely supply-driven inflation shock from broadening into wages, services prices, and inflation expectations before those disinflationary forces take hold.
For now, that argues for additional Fed tightening. But we continue to view this as a policy recalibration rather than the beginning of another prolonged hiking cycle. If inflation remains firm while financial conditions ease, the Fed will likely need to do more. If equities and credit weaken further and longer-term borrowing costs remain elevated, markets can do more of the tightening.
