Was the US Inflation Data a Pivotable Offence?

Summary

• October inflation data for the US was lower than expected, mainly due to an oversized decline in the price of used cars and trucks.
• The figures came as a relief to markets, with risk assets rallying hard on hopes the cooler print would ease pressure on the Fed and prompt a pivot at the December FOMC meeting.
• However, trend indicators, such as median price inflation and the Atlanta Fed median wage estimate, show inflation is not slowing.

Market Implications

• I continue to expect a 75bp hike December and a terminal rate near 8%.

Inflation Remained High in October

US inflation data came in cooler than expected yesterday, with headline falling from 8.2% in September to 7.7% in October. But perhaps the bigger surprise was the market response: the S&P 500 rallied a blistering 5.5%, the NASDAQ 100 was up 7.5%, and even crypto joined in the celebration with bitcoin up 15% despite the FTX chaos.

With the Consumer Price Index (CPI) ostensibly confirming that Fed hiking is working, markets took no time at all to price in a pivot at the December FOMC meeting. Yet I disagree. I think it will take more than a single, noisy print to persuade the Fed the job is done.

Zooming in on the Data

On a six-month annualized basis, which is a less noisy way of measuring the data, core inflation moved sideways (Chart 1). Also, median price inflation at 53bp MoM remained high, even though it was lower than the 67bp in September.

Despite the negative surprise, the CPI still aligned with my big picture macro view. That is for the stabilization of core goods inflation (as supply bottlenecks have not disappeared) and accelerating services inflation (due to the tight labour market). Here is why.

Used Cars Drive the Drop in Core Goods prices

October core goods inflation fell by 38bp MoM, with a 2.4% MoM decline in used car and trucks prices contributing 43bp. In other words, excluding used cars and trucks, core goods inflation was positive.

The ratio of used to new car prices has been falling. This could reflect greater availability of new cars as well as a relative shift in the demand of new vs used cars that itself reflects the strength of consumer demand (Chart 2). New car price increases are slowing. That suggests further downside to used car prices, though falls will likely be smaller than October’s.

Hot Labour Market Lifts Services Prices

October core services inflation increased by 51bp MoM, following a 79bp MoM increase in September.

The most important driver of October core services inflation was again shelter. That increased by 0.8% following a 0.7% increase in September, while OER increased by 0.6% MoM. Shelter represents almost 60% of core services weights.   

Rents and most services are ultimately driven by wages. For that, we turn to the Atlanta Fed median wage estimate. It was 6.4% YoY in October, against 6.3% YoY in September (Chart 3). This is yet another sign that inflation trends have not changed. Longer term, I see wage inflation as more likely to increase than decrease.

Market Consequences

Following the CPI print, markets priced a 50bp in December and shaved off about 15bp from the terminal federal funds rate (FFR).

I disagree with either as the data was very noisy and, regardless, the Fed will consider the macro big picture not a single data point.  Dallas Fed President Lorie Logan’s comments hinted as much: ‘There is still a long way to go. Sufficient cooling of the economy will eventually bring inflation back to our target. But this process is just getting started.’

In addition, a sustained rally in risk assets would soften financial conditions – the last thing the Fed wants when inflation is stuck in a 6-7% range. In that sense, the market rally could be self-defeating.