Don't expect October's CPI to cool enough for Fed pivot

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With inflation being the the Federal Reserve's biggest worry, October's consumer price index has the potential to rattle markets on Thursday.

The headline number is expected to increase 0.6% M/M and 8.0% Y/Y. By contrast, the CPI Index rose 0.4% M/M and 8.2% Y/Y in September. Core CPI, which strips out the volatile prices of food and energy is expected to rise 0.5% M/M, or 6.5% Y/Y, compared with 0.6% and 6.6% in September.

That shows just how far the cost of goods and services has risen above the Fed's target of 2%. In an effort to rein in the rising prices, the central bank has ratcheted up its key policy rate by 375 basis points since March to 3.75%-4.0%, exceeding the previous cycle's peak 2.25%-2.5% in December 2018.

To get to a sub-3% level of Y/Y inflation by mid-2023, the CPI index will have to moderate to rise no more than a 0.2% M/M increase, said Charles Schwab Chief Investment Strategist Liz Ann Sonders.

Uncharted territory: Getting a handle on the course of the economy is complicated by the fact that the pandemic threw the economy into uncharted territory. The massive fiscal stimulus that followed first funneled demand into goods as there was no access to services. As access to services re-opened, demand shifted to those sectors, Sonders said.

"You're already in disinflation for many of the goods-oriented components of metrics like CPI, but it's the services side that has had the more recent lift and in some cases are the stickier components," she said. "It's not the normal economic or inflation cycle, and I think that that switch from goods to services is really important about studying anything about this cycle."

The Fed's lever of raising rates works to lower demand, which eventually results in easing pressure on prices. Some signs of retreating inflation are emerging, with interest-sensitive sectors feeling the effects first as higher borrowing costs maker consumers and businesses cautious about making big purchases.

Shelter impact: Both Sonders and KPMG US Chief Economist Diane Swonk will be looking at shelter prices. Swonk said shelter costs are already coming down, but Sonders sees them staying on the high side for a little longer. There's about a seven- to eight-month lag between rent gauges like the Zillow or RealPage indices and the owner-equivalent rent component of the CPI, she said. "it's coming, but given the variability of the lag, it's hard to pinpoint whether it's going to be this week's CPI or next month's CPI."

Housing prices and and used-vehicle prices are falling, Swonk said. And there are knock-on effects as the lower demand for homes has started to affect demand for appliances. Months ago, homebuilders had ordered appliances to fill a two-year backlog orders. "But they hadn't anticipated the cancellations," she said. "You're starting to see some early discounting in appliances."

The lower demand for housing is apparent in homebuilders' recent quarterly earnings. D.R. Horton (DHI) said the cancellation rate in its fiscal Q4 increased to 32% from 24% in the prior quarter and from 19% a year earlier.

Not all inflation for goods is moderating. New vehicle prices are likely to remain elevated, Swonk said. Gasoline prices are expected to put upward pressure on the CPI in October, Sonders pointed out.

Healthcare quirk: Schwab's Sonders said a quirk in the healthcare component, related to data insurance commissioners provide on retained earnings could have an outsize beneficial impact on the CPI this month. It had been exerting higher pressure on CPI, and "now that's going to reverse and put some downward pressure on CPI," she said. But that may only be a one-month phenomenon, she added.

But overall, Swonk sees health care costs as the "next shoe to drop" in fueling inflation. Dental costs may see an increase. They're not covered as much by insurance as medical costs are, so they aren't subject to the same negotiations by insurers.

Fed determination: Both Sonders and Swonk emphasize that the Fed is serious about keeping rates higher for longer to bring inflation down. And while Fed Chair Powell has indicated the central bank may shift to smaller rate increases, there's no sign of cutting rates. Above all, Powell doesn't want to repeat the Fed's mistake in the 1970s of easing too soon. "It's not hard to overshoot" on Fed policy, Swonk said. "Still, they'd rather overshoot than undershoot."

"They're not going to pivot to rate cuts," Sonders said. "I still think there are a lot of market participants that haven't quite grasped that we're going to stay at a higher plane for maybe a more extended period of time" until the Fed can assess that inflation hasn't re-erupted, she added.

SA contributor Victor Dergunov expects the stock market to "get ugly" if the CPI print doesn't come in cooler than expected. "The S&P 500 is at a crucial inflection point, and a hot inflation print could send stocks, crashing," he said.