Core inflation did not cool as expected. Does the Federal Reserve still have a reason not to raise interest rates?

TL;DR

· Core CPI has exceeded expectations for two consecutive months, weakening the judgment that "underlying inflation is steadily cooling." · The year-on-year increase in core CPI is affected by a low base and rounding, and the monthly increase has not yet decreased, which is more concerning. · Housing and non-housing services have strengthened simultaneously, making it harder for the Federal Reserve to attribute the current inflationary pressures solely to energy fluctuations. · The year-on-year increase in core goods remains flat, indicating that price pressures have not yet fully spread, and premature judgments about a comprehensive rebound in inflation should be avoided. · The rationale for another rate hike in October has strengthened, but the final decision still depends on subsequent inflation, employment, and financial conditions.

Editor’s Note: After raising interest rates in September, the Federal Reserve faces a troubling inflation report. The market originally expected the month-on-month increase in core CPI to fall to 0.2%, but it has remained at 0.3% for the second consecutive month. Meanwhile, housing inflation has stagnated, and non-housing service prices have also strengthened.

For the Federal Reserve, rising oil prices do not necessarily require an immediate rate hike, but if energy prices remain high and core inflation fails to cool, the space for waiting and observing will narrow. Gianluca Benigno believes that the September CPI has strengthened the case for further rate hikes, making the October meeting a possible action window. The key moving forward is whether the remaining data can provide sufficient evidence that underlying inflation is still declining.

The following is the original text:

Core Inflation Continues to Exceed Expectations, Cooling Expectations Once Again Fall Short

What makes the September CPI particularly concerning for the Federal Reserve is that the price increase excluding food and energy has not yet slowed.

The core CPI rose 2.6% year-on-year, higher than the market expectation of 2.5% and August's 2.4%; the seasonally adjusted month-on-month increase was 0.3%, unchanged from August, and exceeded the market expectation of 0.2% for the second consecutive month.

Overall CPI rose 3.7% year-on-year, with a seasonally adjusted month-on-month increase of 0.6%. Gasoline prices increased 9.1% month-on-month, contributing to more than half of the overall CPI's monthly increase, indicating that energy remains the main force pushing up overall prices.

However, the simultaneous rise in energy prices and the lack of decline in core inflation make the policy implications of this report lean more towards tightening. Even temporarily excluding oil price fluctuations, the speed of increase in other consumer prices has not reached the expected slowdown.

The year-on-year core CPI rose from 2.4% to 2.6%, which needs to be interpreted cautiously. According to Benigno's calculations, the unrounded year-on-year increase actually rose from about 2.45% to 2.56%, an increase of about 0.11 percentage points. The low base from the same period last year also amplified the changes in the year-on-year readings.

Therefore, one cannot simply conclude that core inflation has suddenly accelerated significantly based on a 0.2 percentage point increase in the published value. What truly affects policy judgment is the monthly trend: the expected slowdown did not occur, and the 0.3% month-on-month increase in core CPI reappeared. Although this is not sufficient to confirm a new round of inflationary upcycle on its own, it indicates that the Federal Reserve still lacks evidence to confidently pause rate hikes.

Strengthening Housing and Services Weakens the Basis for Continued Waiting

Changes within core inflation are more noteworthy than a single aggregate number.

Previously, the gradual decline in housing inflation was seen as an important force driving core inflation lower. However, in September, this process stalled.

The year-on-year increase in housing prices rose from 3.0% in August to 3.2%, while the seasonally adjusted month-on-month increase rose from 0.3% to 0.4%, contributing to about half of the core CPI increase for the month. Among these, the owner's equivalent rent—an estimate of the rental value of owned housing—saw a month-on-month increase from 0.2% to 0.3%; the rent increase for primary residences remained at 0.2%.

The year-on-year strengthening of housing is partly influenced by a low base, but the acceleration in the seasonally adjusted month-on-month increase indicates that recent price trends have indeed changed. For the Federal Reserve, this means that the components originally expected to continue lowering core inflation have temporarily failed to fulfill their expected role.

Beyond housing, service prices have also remained resilient.

The core service prices excluding housing, often referred to as "super core" service prices, saw their year-on-year increase rise from 3.1% to 3.2%, with the seasonally adjusted month-on-month increase maintaining at 0.3%. Transportation services increased by 0.6% month-on-month, with airfares rising by 1.2%; hospital services and educational services increased by 0.7% and 0.6%, respectively.

Benigno believes that the strengthening of transportation service prices suggests that higher energy costs may be beginning to transmit to some service prices. However, medical, educational, and housing prices each have different driving factors, and these increases cannot all be attributed to oil prices.

The difficulty at the policy level is that energy pressures have not dissipated, and housing and other services have not provided sufficient cooling power. If this combination persists, it will be even harder for the Federal Reserve to rely on waiting to confirm that inflation will naturally decline.

In the goods sector, some relatively mild signals remain. Core goods prices rose 0.7% year-on-year in September, unchanged from August; the year-on-year increase in clothing fell from 3.6% to 3.4%. Although the seasonally adjusted month-on-month increase in core goods rose from 0.1% to 0.3%, there are no signs of a widespread acceleration in year-on-year increases.

This means that a more accurate description currently is that core inflation has become stickier, rather than all areas entering a comprehensive price increase.

Rationale for October Rate Hike Strengthens, but Subsequent Data Confirmation is Still Needed

The Federal Reserve raised interest rates by 25 basis points at the September meeting, increasing the target range for the federal funds rate to 3.75%—4.00%, with all 12 voting members supporting this decision. The policy statement also noted that economic activity is expanding robustly, domestic spending remains resilient, and inflation is still at a high level.

In this context, the September CPI effectively tested a question: Can underlying inflation continue to slow, providing a basis for the Federal Reserve to pause its actions and observe the effects of previous tightening?

This report did not provide the expected support.

The month-on-month core CPI did not decline, and the strengthening of housing and non-housing services weakened the argument for "waiting after the September rate hike." However, a single report cannot measure the full effects of the previous rate hike; the transmission of monetary policy to demand and prices takes time.

Benigno's judgment leans more towards further tightening. According to his understanding of the Federal Reserve's reaction function (how the central bank adjusts policy based on economic data), policymakers will consider the duration of inflation remaining above target, the resilience of the economy and employment, and whether financial conditions are sufficient to constrain demand.

If the economy remains robust, the labor market does not show significant weakness, and core service inflation continues to be strong, the rationale for further rate hikes will strengthen. Conversely, if subsequent data shows clear cooling or financial conditions tighten significantly, there will still be a basis for pausing and observing.

It is also necessary to differentiate indicators: the Federal Reserve measures its 2% inflation target using the PCE price index, and core CPI is an important reference that cannot be mechanically converted into the number of rate hikes based on its deviation from 2%.

For the meeting on October 27-28, it will be important to observe producer prices, inflation expectations, employment, and financial conditions. Among these, whether housing and non-housing services can slow down again will affect the Federal Reserve's judgment on the persistence of price pressures.

The September CPI has not made a rate hike in October a certainty, but it has raised the evidence threshold needed to pause rate hikes. In the absence of a timely cooling in core inflation, if the Federal Reserve chooses to continue waiting, it will need to find more convincing reasons from other data.