CPI Review: What Will It Take to Satisfy the Fed?

Wall Street economists expect Tuesday morning’s release of the consumer price index for August to show a 0.1 percent month-on-month decline, thanks to falling gas prices. This will reduce CPI inflation to 8% from 8.5%. But the outlook for Federal Reserve policy and the Dow Jones depends on what happens to core inflation, which excludes volatile food and energy prices. Core CPI is expected to rise 0.3% on a monthly basis, lifting annual core inflation to 6.1% from 5.9%.




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A softer-than-expected core inflation reading could reduce the chances of the Fed supporting a third straight 75 basis point rate hike on September 21. Financial markets have been pricing in since Monday afternoon 92% chances on another jumbo size move. These huge odds suggest it would take shockingly weak inflation reporting to trigger a 50 basis point move.

However, the modest inflation report could reinforce expectations that the pace of Fed rate hikes will slow after September.

The Fed focuses on core inflation

“Core inflation is a better gauge of inflation,” Fed chief Jerome Powell said at his July 27 news conference.

In previous months, when oil and gas prices rose, the Fed focused on headline inflation. But now that gas prices are falling, the Fed’s stance has changed. Core prices are back in focus, which is a return to normal.

Typically, Powell explained, policymakers can predict a short-term spike in the prices of commodities like oil. But inflation has been too high for too long, so there is an increased risk that households will come to expect higher inflation in the future. This can lead to behavioral changes, such as more aggressive bargaining for wage increases and cost increases – before prices rise even further.

In other words, headline inflation only matters when it’s bad for an extended period, such as in the first half of 2022. So if oil prices start to rise again, the focus could shift again.

The core CPI, which covers 77.4% of household budgets, includes goods other than food and energy. It also includes non-energy services such as rent, medical services, transport and education. Such services make up 56% of household expenditure.


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Goods Vs. Service costs

Core inflation has eased recently, easing to 7% in July from a peak of 12.3% in February. The decline in commodity inflation came as supply chain problems were ironed out, high prices curbed demand and consumers shifted more spending to services, reversing the effects of the pandemic.

“Real spending on goods has declined modestly in each of the past two quarters,” Fed Vice Chairman Lael Brainard said last week.

Retailers like Walmart (WMT) and Target (TGT) cut prices after finding themselves with too much stock.

Still, non-energy price inflation has yet to abate, rising 0.4% month-on-month in July and 5.5% year-on-year. The annual increase matched a 30-year high in June.


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Until inflation begins to decline for this category of spending, the Fed may not be convinced that inflationary pressures are easing. This is because price increases for such services are closely related to a tight labor market and high wage growth. If wages did not rise by more than 5%, large price increases would hurt demand and balance markets.

The August jobs report saw some improvement in labor force participation, pushing the unemployment rate up to 3.7%, despite steady job growth. More of the same could start to ease pressure on wages, but the labor market remains too tight for the Fed right now.

Dow Jones rises ahead of CPI report

On Monday, the Dow Jones Industrial Average rose 0.65% in afternoon stock market action, building on last week’s rally. The S&P 500 rose 0.95% and the Nasdaq Composite rose 1.1%.

Stocks are trying to retrace their slide after Fed chief Powell’s Aug. 26 speech in Jackson Hole, Wyo. Powell’s brief remarks focused on the Fed’s mistakes since the 1970s that fueled double-digit inflation. He signaled that policymakers would keep interest rates higher for longer to avoid a repeat, casting doubt on a pivot to rate cuts in 2023.

Be sure to read IBD The big picture column after each trading day to get the latest information on the prevailing stock market trend and what it means for your trading decisions.

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