Finally, the CPI Report Has Some Good News on Inflation
Fed still seen continuing to raise rates, but at a slower pace and stopping sooner.
After months of worse-than-expected news on inflation from the Consumer Price Index report, there are—at long last—real signs of relief from the surge in prices that has hit the economy over the past year.
In response, bond markets are paring back expectations for how fast and far the Federal Reserve will raise interest rates in coming months. The Fed is now seen raising the federal-funds rate by 0.50 percentage points in December, down from expectations for a 0.75-percentage-point increase. That would still be an aggressive interest-rate hike by historical standards, but it would mark a slowdown from the unprecedented four consecutive 0.75-percentage-point increases made this year.
The October CPI report showed a 0.4% overall increase in inflation for the month, below expectations for a 0.6% increase and the same pace of increase as in September. Excluding food and energy costs, the CPI report showed a 0.3% increase, below the FactSet consensus forecast for a 0.5% increase and down from 0.6% in September.
“It would be premature to celebrate, but today’s inflation report provided early signs that the inflation problem may be resolving,” says Morningstar’s chief U.S. economist Preston Caldwell.
In fact, were it not for some parts of the economy where price trends tend to change more slowly—such as rents—the inflation picture would be looking even better.
That doesn’t mean the markets are out of the woods. With the October CPI report, inflation was still running at a very hot 7.7% annual increase. That’s well above the Fed’s 2% target rate, and many observers say it will take multiple months of good news on inflation before the Fed is ready to pause rate hikes aimed at slowing down the economy, and in turn slowing the upward move in the prices that consumers pay.
That’s especially the case with an economy that has yet to show significant signs of slowing, as was seen in the October jobs report. In addition, when bond yields fall sharply as they did after the CPI report and stocks rally, that makes the Fed’s job in battling inflation harder because both moves can provide support to the economy.
Market expectations for rate hikes at the central bank’s upcoming December meeting moderated following the report, according to the CME FedWatch Tool. Expectations of a fifth 0.75-percentage-point increase have mostly diminished, and the bond futures market now indicates an 80% chance of a 0.50-percentage-point hike at December’s meeting.
The market’s expectations for the Fed’s trajectory also showed signs of softening after the release of the report. The Fed is now expected to take the federal-funds rate toward a target rate of 4.75%-5.00% in 2023, down from 5.00%-5.25%, according to the CME FedWatch Tool. (For Morningstar’s take on the outlook for Fed policy, see our latest update here.)
October’s core inflation reading of 0.3% from month-ago levels was the softest increase since July, a welcome sign for the fight against inflation.
“We should be wary of overreacting to just one month’s worth of data given the statistical noise always present in month-to-month changes,” Caldwell says. “But even in terms of the three-month moving average, we detect a slight downtrend in core inflation.”
The core CPI increased at a 5.8% annual rate in the three months ending in October, down from a peak of 7.9% in June.
Caldwell says that the details behind the core CPI are even more important than the overall number, and that “we have good reason to focus on core inflation excluding shelter prices.”
Shelter prices in the CPI respond with a substantial lag with respect to market conditions, he says. “While this is methodologically sound from the standpoint of gauging cost of living, it does mean that shelter inflation fails to reflect the latest conditions in housing markets.”
Instead, Caldwell says, the reported increase in prices reflects the very high inflation in market rents, such as those measured by indexes including Zillow’s Observed Rent Index, that occurred over the last two years. “The same market rents are now decelerating sharply, which should continue given the falling demand for housing.” Caldwell expects shelter inflation to eventually return back to normal rates.
While shelter prices increased at a 9.1% annual rate in the three months through October, core inflation excluding shelter was just 3.5%. Overall, core inflation excluding shelter has decelerated sharply since the middle of this year, driven by falling inflation for core goods, healthcare, and other services.
The fall in core goods inflation still has a long way to play out, Caldwell says.
Over the past 12 months, prices for airline fares have risen 42.9%. Utility gas services, gasoline, and electricity have also been major contributors to price growth over the year. Year-on-year increases in energy and food indexes were both smaller than for the period ending in September, according to the Bureau of Labor Statistics.
Even so, Caldwell says, “the runup in prices for used cars is now unwinding as supply of cars recovers and demand is hit hard by higher interest rates.” Broad measures of supply chain disruption are converging rapidly back to prepandemic levels, he says.