Inflation uptick puts pressure on Fed to hike again

Brian Kaiser/Bloomberg

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• Key insight: Inflation appears to have gained steam last month, raising the likelihood that the Federal Open Market Committee — or at least a substantial chunk of its voting members — decide to raise interest rates again later this month.
• Expert quote: "The FOMC took an important first step at our September meeting by raising the target range for the federal funds rate 25 basis points. Still, I currently estimate the target range needs to rise an additional 50 basis points or more to appropriately balance the outlook and risks for our dual mandate goals." — Federal Reserve Bank of Dallas President Lorie Logan
• Forward Look: The CPI report is the last major economic indicator ahead of the FOMC's communications blackout period before its next meeting on Oct. 27 and 28.

A surprise jump in inflation last month could force the Federal Open Market Committee to raise interest rates for its second consecutive meeting — or at least strongly consider it.

Price growth regained momentum in September, according to the latest consumer price index reading, with headline inflation rising 3.7% on an annualized basis and core inflation jumping 2.6%. 

The Wednesday release from the Bureau of Labor Statistics upends a months-long trend of declining inflation. The August CPI report showed headline inflation at 3.4% and core at 2.6% Soaring energy prices in September drove the higher-than-expected reading, but rising prices for used cars, transportation and shelter all contributed as well. 

The September inflation print aligns with economic outlooks offered by several Federal Open Market Committee members in recent weeks that described underlying price growth as being too strong and in need of further Fed intervention.

"The FOMC took an important first step at our September meeting by raising the target range for the federal funds rate 25 basis points," said Dallas Fed President Lorie Logan in a speech on Oct. 1. "Still, I currently estimate the target range needs to rise an additional 50 basis points or more to appropriately balance the outlook and risks for our dual mandate goals."

Wednesday's report is the last major economic indicator ahead of the FOMC's next meeting on Oct. 27 and 28. It comes just days before the Fed's pre-meeting communications blackout period, which begins next week. In the meantime, markets are bracing for public commentary from several Fed officials in the days ahead, including Fed Chair Kevin Warsh, who is set to speak at an event in Thailand early Friday morning. 

After the FOMC increased the federal funds rate by 25 basis points last month, financial markets have been left to wonder if the central bank will embark on a series of hikes or if the increase will be a one-off measure. With persistently high inflation having been the impetus for the hike last month, all eyes have been on the October CPI reading to set the tone for what comes next.

"Looking ahead, I will consider what policy rate may be needed to continue to guide inflation down to our target," said Fed Gov. Lisa Cook in late September. "Of course, the number and magnitude of any future adjustments will be informed by observations of the economy's reaction to our policy actions thus far and the inflation and labor data over the coming months."

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The October CPI reading showed a monthly increase of 0.4 percentage point increase in headline inflation and a 0.3% percentage point increase in core CPI, which factors out food and energy prices. On Tuesday, the Federal Reserve Bank of Cleveland's Inflation Nowcast tool projected increases of 27 basis points and 20 basis points, respectively. 

During the past two weeks, markets have largely come to expect the FOMC to hold its benchmark interest rate between 3.75% and 4% at its policy meeting this month. As recently as Sept. 28, federal funds futures markets were pricing in a 70% chance of a quarter-point hike, according to the CME Group's Fedwatch tool. Market sentiment shifted substantially since then, with only 21% of contracts predicting a hike before the CPI report.  

The shift coincided with a series of public remarks from FOMC participants that left the door open for the committee to leave rates unchanged. First, on Sept. 29, New York Fed President John Williams said the September hike meant "there is no need for urgency, and we have time to gather more information."

On Oct. 1, Fed Vice Chair Philip Jefferson acknowledged that bond yields had continued to rise after the FOMC's rate hike — a potential signal that markets were anticipating further tightening — but said the committee would not be pressured to adhere to the private sector's expectations or timeline. 

"My colleagues and I will need to come to our own judgment, which may take more time," Jefferson said. "I will continue to assess whether underlying trends suggest that inflation will return to target with sufficient speed."

Even if the Fed does hold rates steady this month, that does not mean further hikes are not in the offing. In his pivotal speech, Williams noted that he still expects policy to be tightened "late this year." Several other FOMC voters also said they expect more hikes eventually, but did not commit to a specific schedule. 

Markets have followed this logic, albeit to different ends. As of Tuesday, nearly 90% of fed futures contracts expected a rate hike by the end of the year, according to CME Group, with 70% favoring one hike and almost 18% predicting two. 

If the FOMC does use this week's CPI report to justify another rate hike, it may have to do so over the objections of a handful of participants who have favored a wait-and-see approach to inflation.

"I don't currently see an urgent need for further action," Fed Vice Chair for Supervision Michelle Bowman said last week. "And I think we need to better understand the totality of the data but remain attentive to the risks."