What happened

The September CPI release confirmed recent months’ bad news—the price pressures in the US economy are widespread and intense. Core inflation in September was 0.6% month-over-month for the second month in a row, pushing the year-over-year core inflation to a new high of 6.6%, breaching the peak set in March.

The details make clear that the driver of inflation at this stage is the services sector rather than goods prices; that is consistent with the rotation in consumption patterns as well. It also means that even if supply chains continue to heal, that won’t be sufficient to bring inflation under control. Services inflation is heavily influenced by wages, and so it is going to take a meaningful weakening of the labor market to bring inflation to heel.

What happens next?

This all but seals a 75 b.p. hike from the Fed at their November meeting. They’ve said they need to see “several” months of moderating inflation to pause rate hikes. That has clearly not happened yet and is months away at a minimum.

With inflation now being driven by services more than by goods, supply chain bottlenecks clearing will no longer be enough to turn the inflation trend around. Two things are needed to make that happen. First, housing-related inflation must decelerate and second, the labor market must weaken.

As we’ve discussed in the past, shelter costs lag house price rises, meaning the impact of past price increases is still feeding into shelter inflation, which accounts for around 1/3 of the CPI consumption basket. Shelter inflation accounted for almost half of September’s month-over-month core inflation and 2.7% to the year-over-year figure. Even if prices in the rest of the economy were flat, shelter alone would put inflation ahead of the Fed’s 2% target. With a lag of over a year for house price increases to filter into the CPI and a house price inflation peak six months ago, we are still months away from any relief on this front.

In addition, services inflation is closely tied to wages. With the labor market still adding around 250K jobs/month and the unemployment rate at 3.5%, it will be hard to moderate services inflation until that changes.

The Fed’s choice

After an almost-certain 75 b.p. hike in November, the Fed will have a few choices on its next steps.

1. They could simply stick to the current guidance and wait for inflation to moderate before slowing the pace. If we think of “several” as meaning “at least 3,” they are locked into 75 b.p. hikes in November and December and a policy rate that may well be north of 5% in Q1 next year assuming small hikes in February and/or March 2023. This has the obvious benefit of simplicity, and it is consistent with Chair Powell’s general preference to see evidence rather than relying on forecasts. It has the obvious drawback, however, of significantly increasing the severity of the coming economic downturn, perhaps unnecessarily.
2. They could start to change their guidance, suggesting that they might slow and even stop the pace of tightening even if inflation is still high. The way to do that is to describe the policy setting in reference to the neutral rate (2.5%–3.0%) and observe that with policy significantly above neutral, they believe that there is enough tightening in train to bring inflation under control. Because the typical time lag for monetary policy to impact the economy is 9–12 months, that logic makes sense—we have yet to see the full impact of what they have already done. Inflation expectations are well anchored, which gives them the opportunity to take this route if they choose to. The obvious benefit is that it reduces the risk of overshooting; the obvious drawback is that it increases the risk of undershooting.

For now, we expect the Fed to remain hawkish. They have to recognize the limits of relying on forecasts, given how badly forecasts have performed in recent years. But if house prices fall and/or the labor market slows, the hawkish arguments may hold less sway. We’re going to pay close attention to the Fed’s messaging after the November meeting and see if they begin to shift their messaging or reaction function.

We should expect a more robust range of thoughts from FOMC members, some of whom are likely to stick to being reactive and some of whom will want to slow down at some point in the coming months. That said, we expect that even the most dovish among the FOMC members will agree that it is far too early to pause, much less pivot. Maybe in a few months, but not yet. The reality is that it is going to take a meaningful economic slowdown to get inflation under control, and thus far, we have only seen limited evidence that that process is occurring.