US CPI Preview: Energy Set to Lift Headline Inflation, Core Seen Steady

What happened

The US Consumer Price Index (CPI) report for September, due on Wednesday, is highly anticipated, especially as it is the last inflation data release before the Federal Reserve's (Fed) October 27-28 meeting. Market projections indicate that headline CPI is expected to rise by 0.6% month-on-month, pushing the annual rate to around 3.7% from 3.4% in August. This would mark the sharpest monthly increase since April and the highest annual level in four months.

The primary driver of this increase is the energy component, which is expected to climb by approximately 5.5% for the month, led by gasoline. In contrast, core inflation (excluding food and energy) is anticipated to present a calmer picture, with a projected rise of around 0.2% month-on-month, slowing from August's 0.3%, and keeping the annual core rate at 2.4%. This divergence between headline and core inflation is attributed to factors such as the correction of volatile items (hotel prices and used cars) and the pass-through of higher jet fuel costs to airfares.

Why it matters

The distinction between energy-driven headline inflation and more contained core inflation creates a dilemma for the Federal Reserve. Although the Fed raised its target range to 3.75%-4.00% on September 16, the odds of a follow-up move at the October meeting have fallen to around one in four after September payrolls showed only 29,000 jobs added. However, markets still largely price in a December hike.

An elevated energy component, as expected, reinforces the link between crude risk and Fed policy. If core inflation comes in stronger than anticipated, it could revive October hike pricing. Conversely, a softer core would tend to reinforce expectations that the Fed will wait until December for any additional moves.

Market impact

• Interest Rates and Treasuries: A softer core inflation reading would favor the front end of the Treasury curve, leading to a drop in yields. A firmer core, however, could revive October rate hike expectations, pushing yields higher, especially on the short end.
• Dollar and FX: A soft core inflation reading would tend to weigh on the dollar, signaling less pressure for the Fed to tighten monetary policy. A firm core, conversely, could strengthen the dollar due to increased rate hike expectations.
• Equities: A scenario of contained core inflation, even with higher headline inflation, might be viewed positively by equities as it would reduce the need for aggressive Fed tightening. However, a firm core that revives October hike bets could lead to volatility and downward pressure.
• Commodities: The energy component is already the main driver of headline inflation. If oil prices remain elevated, this will maintain inflationary pressure and focus on energy commodities.
• Gold: Gold would likely benefit from a soft core inflation reading and lower yields, as it becomes more attractive as a non-yielding safe-haven asset.
• Brazil: US CPI dynamics, especially the core, directly influence expectations for Fed monetary policy. A more dovish Fed (due to a weak core) tends to favor the real and Brazilian risk assets, while a more hawkish Fed (due to a strong core) can generate depreciation pressure on the real and capital outflows.

What to watch

Investors should closely monitor the September CPI data, with a particular focus on the core component. Additionally, producer prices (PPI) and retail sales data, due on Thursday, will provide further insights into the economy's health. Fed Chair Kevin Warsh's remarks in Bangkok on Friday will be his last before the Fed meeting and may offer clues about the direction of monetary policy.

Scenarios

Base Case: Headline inflation elevated due to energy, but core in line with expectations (0.2% monthly). This would reinforce the view of a December hike, keeping October odds low. Risk Scenario: Core inflation stronger than expected (above 0.2% monthly), combined with high energy prices. This could revive Fed rate hike bets for October, leading to market volatility.

Original source: ForexLive (InvestingLive). For information only, not investment advice.