Inflation Comes in Hotter than Expected: What Does it Mean for Rates?

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The big economic news of the week centered on inflation, as the Bureau of Labor Statistics (BLS) released its monthly reports on prices. Inflation rates as measured by the Producers Price Index (PPI) and the Consumer Price Index (CPI) came in a little hotter than expected in September.

That begins speculation on what the Federal Reserve will do at its next Federal Open Markets Committee (FOMC) meeting on Oct. 31 – Nov. 1. The Fed has been raising rates for a year and a half to tame inflation, and while it is way down, the question now is whether the Fed will see September’s numbers as a reason to keep hiking rates.

Inflation rates unchanged

The CPI, which measures inflation rates for the products consumers buy, rose 0.4% month over month in September. However, the headline number, which is the one the Fed tracks more closely, is the year-over-year rate, which held steady at 3.7%.

In fact, the 3.7% inflation rate over the past 12 months is slightly higher than expected. Economists had predicted a monthly increase of 0.3% and a year-over-year rise of 3.6%. As a result, the stock markets were down slightly on Thursday morning after the CPI was released.

Yesterday, the BLS released the September PPI, which is the measure of prices that producers, or businesses, receive for their products. The PPI rose 0.5% in September, which was lower than the 0.7% increase in August but higher than the 0.3% reading anticipated by economists.

Going back to the CPI, the core inflation number, which excludes the more volatile food and energy prices, was in line with expectations, up 0.3% in September and 4.1% year over year. Further, the core CPI in September was down from 4.3% in August.

The primary reason for the higher-than-expected inflation numbers is the cost for shelter, meaning housing and rent. The shelter index has risen 7.2% over the past 12 months, accounting for 70% of the total core CPI increase. Food prices have somewhat stabilized, as the food-at-home index is up 2.4%, while the food-away-from-home reading is still high, at 6%.

What will the Fed do?

The Fed’s target for inflation is 2%, and its rate hikes have helped drive down inflation over the past 18 months. Now that the 2% goal is in sight, the Fed has dialed back its increases and even paused rate hikes at its last meeting in September, holding them at the 5.25% to 5.5% range. However, will this slightly hotter CPI report cause the Fed to continue its rate hikes?

Some insights may be gleaned from various speeches made by Fed officials this week. Fed Vice Chair Philip Jefferson suggested that the increase in Treasury yields could have the effect of cooling inflation without the need for more rate hikes.

“Looking ahead, I will remain cognizant of the tightening in financial conditions through higher bond yields and will keep that in mind as I assess the future path of policy,” Jefferson said Monday at a National Association for Business Economics meeting.

Lorie Logan, the head of the Dallas Fed, said something similar on Monday at that same meeting, although she used more direct terms.

“Financial conditions have tightened notably in recent months, but the reasons for the tightening matter,” she said. “If long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed funds rate. However, to the extent that strength in the economy is behind the increase in long-term interest rates, the FOMC may need to do more. So I will be carefully evaluating both economic and financial developments to assess the extent of additional policy firming that may be appropriate to deliver on the FOMC’s mandate.”

These comments were made before the CPI report came out. However, given the decline in the core CPI reading and the fact that the overall CPI number held steady, their views likely remain the same.

Fed officials, and investors, for that matter, should be watching the Personal Consumption Expenditures (PCE) index, which comes out on Oct. 27, just days before the next FOMC meeting. The PCE is the U.S. Bureau of Economic Analysis’ (BEA) measure of consumer prices and inflation, and it should provide more insight into what the Fed might do.