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By: Jose Torres Interactive Brokers’ Senior Economist

The CPI came in hotter than expected at 8.3 percent on a year-over-year basis while the core segment which excludes food and energy due to their volatile characteristics was up 6.3 percent. Headline and core both accelerated on a month-over-month basis at 0.1 and 0.6 percent respectively. While gasoline prices have fallen significantly against the backdrop of increased supply from the Strategic Petroleum Reserve (SPR), decreased demand due to Chinese lockdowns and slowing economic conditions, overall inflation continues to rise. Lofty price increases in rents, food, and medical care offset all of the progress made on the gasoline front and then some. Furthermore, all major categories ex-energy experienced price increases from July to August with used cars being the small exception experiencing a modest m/m decline of 0.1 percent.

Looking ahead, the first winter since the start of the armed conflict in Eastern Europe may not provide a positive backdrop for lower gasoline prices, which have supported lower inflation readings in the second half of 2022. The geopolitical conflict in Europe alongside a probable October halt in SPR oil releases can contribute to a new leg higher in oil prices, complicating the Fed’s 2 percent inflation goals. Food prices at the supermarket and at dining establishments continue to be propelled by a stressed commodity complex, geopolitical tensions, unfavorable climate conditions and labor shortages. Rents are likely to continue rising as housing affordability remains stretched, pushing prospective buyers into the rental market at a time of a structural housing shortage. Labor shortages and elevated levels of liquidity will continue to push up prices in the services segments as companies pass on rising costs to consumers. Consumers have the capacity to continue to pay higher costs as they’re supported by a tight labor market with growing wages, excess savings from the pandemic and elevated credit card spending.

The August inflation reading must worry the Fed as they are primarily focused on core m/m changes which accelerated from 0.3 percent in July to 0.6 percent in August. Continued price pressures pose the risk of inflation becoming increasingly entrenched in the economy as well as in people and firm psychology, affecting behaviors. Fed tightening has contributed to price cooling which takes a while to work its way through the economy and thus far it hasn’t been nearly enough. Services and rent are not volatile like gasoline, are characterized by price stickiness and will require further increases in the unemployment rate to cool off. Expectations of another super-sized 75 basis point hike in November rose to 49 percent this morning, a very unlikely scenario just a couple of hours ago.

Yesterday we wrote, “While the equity market may cheer another reduction in headline inflation, rising core prices, a weak seasonal period, rising yields and overbought conditions in the short-term suggest a bearish response. The market is more likely to view this report through a bearish lens as Fed hawkishness and rising yields become the primary focus.” The market has been quick to cheer the idea of a Fed pivot and slower inflation without fully pricing in the negative implications for corporate earnings and valuations. Quantitative tightening just started a few months ago, is ramping up to double the level and we have yet to feel the full effects of tighter policy coming down the pipeline. The effects are negative for earnings prospects due to slowing consumption and borrowing while also negative for valuations because it props up bond yields which makes risk assets like high-beta stocks and cryptocurrency less attractive.

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