US CPI disappoints expectations

Inflation data suggests Fed will cut by 25bps next month

Today’s US inflation report was good, but not good enough to dispel fears that US inflation could reignite in the coming months. The headline rate moderated to 2.4% in September, down from 2.5%, but the core rate rose to 3.3% from 3.2% in August. The largest upside contributors to inflation included service sector inflation, electricity prices and food prices, which rose by 0.4% MoM, stemming a trend of deflation for food prices. On the positive side, rent costs fell last month.

Consumers pay up for sports tickets

Drilling down even further there were large upside price gains for jewelry and watches, their prices rose by more than 5% compared to September 2023. College textbooks jumped by 4.2% YoY at the start of the new school year, and tickets for sporting events rose by a whopping 10.9% last month. This was the largest price increase ever recorded. Overall, these price rises suggest that the consumer is still willing to splurge on fun activities, which is a sign of a healthy jobs market. Last Friday’s jobs report showed an increase in wage growth for September, and today’s CPI report suggests that consumers are spending the extra cash in their pockets.

US economic data continues to surprise on the upside

The monster jobs report for September and today’s upside surprise for inflation, although mild, is part of a broader trend of stronger US economic data since September. Citi’s US Economic Surprise Index is at its highest level since April, and the Atlanta Fed’s GDPNow model is predicting a 3.2% growth rate for GDP for Q3. Today’s CPI report supports expectations for a strong economy. Real average hourly wages for September rose by 1.5% YoY, which is the highest level since 2021. Wages adjusted for inflation are growing at a decent clip, which may give the Fed pause for thought ahead of their next meeting in November.

November rate cut still expected

Now that the dust has settled on the US CPI report, the market is expecting a 25bp rate cut from the Feed next month. There is now an 89% probability of a 25bp cut next month, this is up from an 85% chance earlier on Thursday. The market has marginally scaled back their expectations of no rate cut from the Fed at next month’s meeting. Although there are some worrying trends in this report, headline inflation is still coming down, which supports a further rate cut next month, although the direction of monetary policy after that is not clear.

We believe that there could be a lot more volatility to come for the Fed Fund Futures market, and investors may be underestimating the upside risks to inflation further down the line. There are 84bps of cuts priced in up to March 2025, and there are still just over 6 rate cuts priced in between November and October 2025. The risk is that market expectations for rate cuts from the Fed are too high.

Upside risks to inflation

There are two factors that are worth worrying about in the US inflation outlook right now: 1, the reliance on weaker energy prices to weigh down headline inflation and 2, the uptick in service prices. Annualized declines in energy prices helped inflation to tick lower last month. Energy prices were lower by 6.8% compared to 12 months ago, and gasoline prices were down by more than 15%. However, those declines may start to get reversed if geopolitical risks and China stimulus measures push up the cost of commodities. For example, WTI crude oil is higher by 13% in the past month, and gasoline prices are up by more than 12%. These price increases translate to inflation in the US pipeline. We may not have seen it in today’s report, but it could add upside pressure to prices in the longer term. If inflation reverses course and starts to rise later this year, then the Fed rate cuts are likely to be rapidly priced out, and the upside pressure on the dollar may continue to build.

The market reaction

The market reaction to the US CPI report has been mild for the dollar and the bond market. The dollar index initially spiked higher, but it has since slipped to the lows of the day, although the dollar index is still close to its highest level in 2 months. The 2-year bond yield, which is sensitive to changes in interest rate expectations, is down 5 bps since the report and has backed away from the key 4% level. Heading into the CPI report the 10-year yield was above 4%, and it is higher by 1bp after the CPI report and extending gains above 4.08%. The yield curve is steepening, which is supportive of a strong economy, however, we think that the market continues to underprice US inflation risks.

US stock markets have opened lower and have slipped back from record highs. However, while US economic data and Fed rate cuts matter for US stocks, the start of the Q3 earnings season is more important in the short term. Friday’s bank earnings will be watched closely, especially after Delta Airlines reported risks associated with the US election for Q4 revenue prospects, its share price is down more than 2% on Thursday.