Hot August Inflation May Shift Fed’s Interest Rate Trajectory Higher
The U.S. had another scorching CPI (Consumer Price Index) report. Stickier and broader-based inflation through August suggests the Federal Reserve has more work to do to contain price increases, and the odds of a hard landing for the U.S. economy continue to rise. We may see a faster pace of Fed rate hikes to a higher terminal fed funds rate than what was previously expected.
After the July CPI report set up some hope that both headline and core inflation were moderating, the August CPI report significantly outpaced consensus expectations. More concerning, the details were firm, with broad-based reacceleration in prices across most goods and services categories. Given the softening price news in several high-frequency indicators in recent months (purchasing managers’ indexes (PMIs), shipping, retail inventories, Manheim used car index, etc.), even after adjusting for the usual lags, it seems easing input prices are not yet filtering through to consumer prices. This suggests many companies are maintaining price markups via a slower pass-through of easing input costs, consistent with the view that it’s going to take more time for inflation to moderate.
Inflation report details: rent, retail, cars, travel
U.S. rental inflation measures were once again extremely strong in August, as rents and owners’ equivalent rents (OER) both reaccelerated 0.7% month-over-month (m/m), slightly more than expected. We continue to expect the year-over-year rate of rents and OER to accelerate up to 8% – well above the 3.5% pre-pandemic trend. Counterintuitively, Fed rate hikes historically have tended to boost rental inflation at first, because they make owning a home less affordable, consistent with the behavior seen over the past several months. It’s not until housing price inflation starts to more materially moderate that rental inflation also starts to fall (typically after three to six quarters). Furthermore, with a general absence in rent controls outside of major U.S. cities, price adjustments in lease renewals have been much stronger in the face of high price hikes for lease turnovers, resulting in a higher “beta” than we’ve witnessed historically. This has also boosted the reported rate of rental inflation, since the Bureau of Labor Statistics (BLS, which publishes the CPI) surveys both lease renewals and turnovers. Given that these rental measures make up such a large part of the CPI basket and will take time to moderate, it underscores the challenge Fed officials are facing over the next several quarters.
Goods price inflation reaccelerated in August after the small reprieve in July (which likely reflected discounting related to Amazon Prime Day). Furnishings (+1.1% m/m), apparel (+0.2% m/m), and recreation goods (+0.6% m/m) all saw notable reacceleration. Despite significant improvement in logistical bottlenecks and a surge in inventory/sales ratios for most U.S. retail goods, consumer inflation across goods categories has been very sticky. This suggests retailers were quick to adjust prices on the upside, but have been more cautious about passing along easing input price pressures to consumers, as they face margin pressures from rising labor costs and lower volumes.
U.S. used car prices were also stronger than expected. Despite the recent weakness in wholesale prices, used car CPI was little changed in August (−0.1% m/m). New car prices rose 0.8% m/m. While new auto production remains severely disrupted and inventories near record low levels, the used car market has returned to better balance in recent months. Inventories have improved, and the Manheim used vehicle value index is now down about 11% from the peak. However, this moderation is worryingly absent from the August CPI report. Historically, CPI prices have followed the Manheim data with a lag of about two months – the fact this didn’t happen suggests dealers are not passing on lower prices to consumers.
Travel services prices were mixed in August after declining in July. Airfares were lower (−4.6% m/m), consistent with pass-through from lower fuel prices. Hotel prices were unchanged. The August report suggests much of the weakness in July could be attributed to categories more volatile than travel.
Implications for Fed policy and U.S. growth outlook
The August CPI report suggests U.S. inflation will take longer to decline. Fed officials are already in the blackout period ahead of their 20–21 September meeting, and we (and markets) still believe a 75-basis-point hike is likely. In our view, rather than prompting a more dramatic move at the next meeting (such as a larger hike), the latest CPI data instead argues strongly for a shift higher in the “dots” – i.e., Fed officials’ near- and longer-term forecasts for the fed funds rate. New projections will be released at the September meeting, and we expect to see a higher forecasted median terminal rate of 4.5% – suggesting the Fed has more hiking to do before it pivots to keeping the fed funds rate on hold, as the more gradual pace of disinflation calls for more hawkish policy in an effort to keep inflation expectations from rising further.
Tighter U.S. financial conditions and a higher fed funds rate trajectory also suggest the path to a soft landing continues to narrow, and a U.S. recession may be more likely than not in the next 12 months.
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