US Inflation in Focus: Energy Drives Headline, But Core CPI Dictates Fed's Next Moves

What happened

MUFG, in its analysis of the US Consumer Price Index (CPI) for September, projects headline inflation to reach 3.6%. This increase is almost entirely attributed to rising energy prices, a reflection of the US-Iran conflict. However, the bank emphasizes that the primary focus for the Federal Reserve (Fed) and markets will be on core inflation, which excludes volatile food and energy prices.

Following a 0.3% month-on-month increase in August, driven by services, MUFG expects core inflation to ease to 0.2% in September. The institution notes that an upside surprise in core CPI would likely be needed to revive market expectations of a back-to-back rate hike by the Fed as early as this month. October hike bets have significantly faded after the September payrolls report showed only 29,000 new jobs added, shifting the main scenario to a December hike.

In addition to the CPI, other key data this week include September retail sales, expected to confirm strong consumer spending growth in the third quarter, indicating the economy's ability to absorb higher energy costs and tighter monetary policy. The week will also feature the first public remarks from Fed Chair Kevin Warsh since the September FOMC meeting, during the IMF Annual Meetings in Bangkok, which will be scrutinized for guidance ahead of the October 27-28 decision.

Why it matters

The dynamic between headline inflation, driven by energy, and core inflation is crucial for the Fed's monetary policy. If core inflation remains contained, even with headline inflation rising, it could indicate that price pressures are not broadly spreading through the economy, giving the Fed more flexibility to keep rates stable or adopt a more gradual approach. Conversely, a surprisingly high core reading would signal that inflation is becoming more entrenched, requiring a more aggressive response from the central bank.

The Fed's interest rate decisions have direct implications for borrowing costs, economic growth, and asset valuations globally. The perception that the US economy can absorb tighter policies, as indicated by retail sales, reinforces the Fed's ability to act if necessary. Warsh's remarks, while not explicit forward guidance, will be important for gauging the Fed's tone on inflation and the economic outlook.

Market impact

• Interest rates and bonds: An in-line core CPI (0.2%) would likely keep October Fed hike pricing subdued, resulting in more stable Treasury yields. An upside surprise in core (a repeat of 0.3% or higher) would tend to revive bets on an October rate hike, pushing up short-term Treasury yields. Strong retail sales data would reinforce the case that the economy can absorb tighter policy, potentially adding upward pressure to yields.
• Dollar and FX: An in-line core CPI would tend to keep the dollar range-bound. A stronger-than-expected core reading, which revives Fed hike expectations, would tend to strengthen the dollar, as higher US interest rates make dollar-denominated assets more attractive. The Brazilian real, like other emerging market currencies, would tend to depreciate against a stronger dollar.
• Equities: An in-line core CPI without upside surprises, which keeps Fed hike expectations in check, could be viewed positively by equity markets, as it reduces pressure on corporate earnings. However, a surprisingly high core reading, signaling more monetary tightening, would tend to negatively pressure equities, especially interest-rate-sensitive sectors. Robust retail sales data could be interpreted as a sign of economic strength, but could also fuel inflation and Fed concerns.
• Commodities: Oil prices are already tightly linked to Fed expectations and the US-Iran conflict. A core CPI signaling monetary tightening could lead to concerns about global demand, potentially putting downward pressure on commodity prices, although the geopolitical factor remains dominant for oil.
• Brazil: The global interest rate environment and the dollar are key factors for Brazil. A more hawkish Fed, driven by persistent core inflation, would tend to increase global risk aversion, pushing up Brazilian bond yields and putting downward pressure on the real. A scenario of controlled US inflation and a less aggressive Fed would be more favorable for Brazilian assets, allowing the Copom greater flexibility in its own monetary policy.

What to watch

• US CPI report (Wednesday): Focus on core inflation (excluding food and energy) for signs of price pressures spreading beyond energy.
• US Retail Sales (Thursday): To confirm consumer resilience and the economy's ability to absorb tighter policies.
• Fed Chair Kevin Warsh's comments (Friday): To gauge the Fed's tone on inflation and the economic outlook, especially ahead of the October meeting.

Scenarios

Base Case: Core inflation in line at 0.2%, keeping October Fed hike expectations subdued and the dollar/Treasuries range-bound. The Fed will likely maintain a wait-and-see approach before any move. Risk Scenario: Core inflation surprises to the upside (0.3% or more), reviving bets on an October Fed rate hike and leading to an increase in Treasury yields and a stronger dollar.

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