CPI Report: Inflation Comes In Hotter Than Expected, But Most Still Think The Fed Will Hold Interest Rates Steady

Key takeaways

• Headline inflation rose by 0.6% for August, the biggest monthly increase in over a year
• But core inflation has decelerated to 4.3%, the lowest result since September 2021
• The results didn’t dissuade investors from the view that the Fed will hold interest rates steady at the next meeting

The latest inflation data was released yesterday, with headline inflation showing the biggest increase since June last year. The inflation rise was explainable, allaying concerns from investors that the inflation battle is turning into a war, but the Fed may not be so charitable with its own view.

The market reaction was one of continued optimism, with the stock market and dollar rising. A short-term positive reaction may be warranted, but the inflation data was a mixed bag and points to some long-term issues the Fed may face in bringing inflation in line.

Here’s the latest on the inflation report, what it all means and why investors are largely shrugging off the most significant inflation jump in over a year.

What was the latest inflation data?

The latest consumer price index (CPI) report revealed a 0.6% jump in headline inflation for August, the biggest increase since June 2022, pushing the year-over-year increase to 3.7%. That’s a sizeable lift from July’s 3.2% result and above analysts’ consensus estimate of 3.6%.

It’s the second increase in a month for headline inflation, this time driven by a spike in energy prices, which rose 5.6% for the month, and a surge in gasoline which contributed a 10.6% increase.

Shelter costs continue to be a driver, rising 0.3% over the month and marking a 40th straight month of gains. The rent of primary residence index increased by 0.5% and rose by 7.8% compared to a year ago. Owners’ equivalent rent, a metric that assesses what homeowners could achieve for renting their home, climbed by 0.4%, which is a 7.3% yearly increase.

Gas prices and shelter costs are explainable. Used car prices, which had been a concerning factor in pushing up inflation, declined by 1.2% and are down 6.6% for the year. But there was also an increase in transportation and medical care sector costs in August, with the former rising by 2%, and airfares jumped by 4.9%, though they’re still down 13.3% from the same time last year.

However, core inflation was the real winner of the report. For August, the gauge rose 0.3% over the month and decelerated to a 4.3% annual pace, which is the lowest core inflation reading since September 2021. Consensus predictions had been for a 0.2% monthly increase and a 4.3% annual rise.

Is there any other economic data?

On the same day, the Labor Department released new data on worker earnings, which unveiled a jump in headline inflation hit American pay packets. Actual average hourly earnings declined by 0.5% for the month but are still 0.5% higher than the same time last year.

It’s another sign the red-hot labor market is finally weakening, in line with other recent data we’ve seen on jobs. The August unemployment rate was at 3.8%, a high not seen since February 2022. Contrastingly, nonfarm payrolls increased by 187,000 for the month, which was well above the Dow Jones forecast of 170,000.

As for the personal-consumption expenditures price (PCE) index, headline and core inflation for July increased, but precisely in line with economists’ expectations. July’s core PCE inflation reading was 4.2% annually, while headline PCE inflation was 3.3%, which was driven by an uptick in prices for services rather than goods.

How did the markets react?

The dollar index closed higher on Wednesday by 0.19% to 104.79. The euro lost 0.22% against the dollar ahead of the European Central Bank’s own policy announcements today. Treasury yields were down very slightly, with the ten-year hitting 4.248% and the two-year falling to 4.984%.

The markets were mixed after the CPI news, with the S&P 500 rising by 0.1%, the Nasdaq climbing 0.3% higher and the Dow Jones Industrial Average falling 0.2%. Stock market futures initially fell at the report’s release but rebounded by the end of the trading day.

Will the Fed raise interest rates this month?

The Fed is meeting next week to decide the fate of U.S. interest rates, though the latest data didn’t dissuade markets from predicting the Fed will hold them steady – in fact, it made them even more convinced.

The CME FedWatch tool now has the likeliness of a September interest rate pause at 97%, up from 92% on Tuesday. Expectations for a quarter-point hike in November had been slowly rising but fell from 41.1% on Tuesday to 40.8% yesterday.

Why is that when inflation went up? Because it matters which parts of inflation rose. Energy and food prices are known volatile elements driven by extraneous factors, whereas rising core inflation would suggest a domestic problem.

The fact that core inflation is now at its lowest levels in two years gives the markets and Fed some optimism that the monetary tightening cycle is working – and maybe ending. Interest rates are already at a target range of 5.25% to 5.5%, the highest in 22 years.

Are there any inflation headwinds?

In August, U.S. consumer debt topped $1 trillion in the second quarter of 2023 for the first time ever, according to the New York Fed. That’s a 4.6% increase from the first quarter, which was $986 billion.

Credit card delinquency rates have also risen from 5.08% this year compared to 3.35% last year. In short – the average American consumer has run out of savings and relies on credit card debt to get by.

Student loan repayments have also resumed after a three-year forgiveness period. Higher education debt has tripled since the 2008 financial crisis, with U.S. households collectively owing $1.6 trillion in debt.

The anticipated impact is a further slowdown in consumer spending that could even spark a recession, given the price increases households have already faced for the last two years. Morgan Stanley predicts most paying back student debt will see their disposable incomes reduced by 0.3% to 0.5% a year.

But housing, which has been a persistent thorn in inflation’s side for the last two years, is expected to soften after a record rate of large multi-family housebuilding projects was recorded in July. A new Redfin report showed asking rents neared record levels in August, but landlords offering more incentives have softened competition for rentals.

The bottom line

It was another mixed bag for the inflation results, but they weren’t enough to change anyone’s mind that the Fed will keep interest rates steady in September. Only the Fed knows what it will decide, and the tone of Fed members has been persistently hawkish in recent months, but they won’t want to spook the markets.

Besides, the core inflation result was promising, and concerns over shelter and gasoline prices are set to disappear. There are still worries over consumer debt and student loans to be dealt with, but it’s one step at a time when it comes to beating inflation.