US CPI: A lethargic path back to target

What happened? 

Today’s CPI report suggests inflation accelerated in September, driven primarily by another sharp increase in energy prices, while underlying inflation pressures remained relatively firm. Headline CPI rose +0.6% MoM, up from +0.4% in August, while the annual headline inflation rate increased to +3.7% YoY from +3.4% YoY the prior month. Core CPI, which excludes food and energy, increased +0.3% MoM, unchanged from August, while the annual core rate rose to +2.6% from +2.4%. Services excluding energy services also firmed, rising +0.4% MoM and +3.1% YoY, while shelter inflation accelerated modestly. Taken together, the report suggests that September’s increase in headline inflation was heavily influenced by energy, although underlying price pressures remained persistent.

Delving deeper into the report, we see that energy was again the primary contributor to the monthly increase in headline inflation. The energy index rose +5.2% MoM after increasing +2.1% MoM in August, driven largely by a +9.1% MoM rise in gasoline prices, which accounted for more than half of the overall monthly CPI increase. Food prices were unchanged during the month and increased +2.5% YoY, with food at home declining -0.1% and food away from home rising +0.2%. Shelter increased +0.4% MoM and +3.2% YoY. Elsewhere within core categories, used cars and trucks rose +0.7%, recreation +0.5%, airline fares +1.2%, and education +0.6%, while communication prices declined -0.2%.

September’s report complicates the monetary policy outlook, as inflation remained firmer than expected and price pressures broadened beyond the sharp increase in energy costs. Gains across shelter, vehicles and apparel point to continued underlying inflation pressures, reinforcing the view that progress toward the Federal Reserve’s 2% objective is likely to remain uneven and gradual.

What does it mean for investors? 

Today’s CPI report gave the doves little to work with. Headline CPI rose 0.6% MoM, in line with the Bloomberg consensus estimate, while the 3.7% YoY increase slightly exceeded expectations of 3.6%. More discouraging was core CPI, which rose 0.3% MoM and 2.6% YoY, above consensus estimates of 0.2% and 2.5%, respectively. Shelter prices rose 0.4%, interrupting the recent disinflationary trend that had been expected to help moderate inflation moving forward. Today’s release certainly makes it more difficult for the Fed to stay on the sideline. In turn, market pricing for a 25 bps rate hike at the October meeting rose to roughly 57% following the release, a meaningful shift from the 24% probability priced in as of yesterday.

The Treasury market response has been decisive this morning, with yields reversing their earlier declines following the release. The most pronounced move is at the front end, where two-year yields rose roughly 15 bps to 4.94%, hovering near a 52-week high at the time of writing. The 2s10s Treasury spread has flattened from 53 bps on October 8 to 37 bps today, with bear flattening extending that recent trend as investors reassess the near-term policy path. The dollar also strengthened, with the US dollar (DXY) reaching a fresh YTD high. Euro weakness has been the primary driver, with EURUSD falling to a fresh YTD low. Gold fell nearly 2% off the combination of higher Treasury yields and a stronger dollar. S&P 500 futures fell to session lows following the release. From an S&P 500 GICS sector standpoint, Information Technology, Financials, and Consumer Discretionary were the weakest performers at the time of writing. At the opposite end of the spectrum, leadership had a defensive tilt, with Health Care and Consumer Staples among the strongest performers, alongside Energy.

For investors, the concern is that higher energy prices are becoming an X-axis problem (duration) as much as a Y-axis problem (magnitude). The longer prices stay elevated, the greater the risk that higher costs flow through supply chains and ultimately into broader consumer prices. The shelter rebound and broader services pressure also make it harder to look through the headline acceleration. Stocks have largely shrugged off rising rates at the index level this year, but a more restrictive policy outlook adds pressure heading into an earnings season already marked by high expectations and little margin for error.