Inflation And The Fed

The stock market may continue to be weighed down by concerns regarding AI, Iran war and the Fed this week, after last week's data releases underscored a persistent inflation problem.  From the Fed's and market's perspectives, the question is whether non-economic factors -- AI, tariffs and Iran war -- are behind the high inflation prints and whether the impact from these factors will dissipate over time.  If this is the case, then a gradual approach to tightening would likely be appropriate.  A breakdown of the September CPI suggests these factors are playing a significant role but may not be the whole story.  It remains an open question whether the Fed will engage in only modest additional tightening after skipping a rate hike at the October 27-28 FOMC Meeting.

The high September CPI (+0.6% m/m Total and +0.3% Core) showed widespread price increases.  Two-thirds of the major Core components had increases that exceeded their prior 3-month average.  They appeared to be high for a variety of reasons, including AI, tariffs and the Iran war.

Some of the large price increases were just catch-up after declines or flat prints in prior months or by components that are typically volatile.  For example, a 2.0% jump in the volatile Lodging Away From Home -- all because of a boost from seasonal factors -- contributed a notable 0.04% pt to the Core CPI.  However, there is more to the story than just volatility in some components.  The Cleveland Fed's Trimmed Mean CPI -- which eliminates outliers -- sped up to 0.3% m/m from 0.2%.    

Many price increases could have resulted from AI-related shortages, e.g., computers (higher-priced memory), or from the jump in oil prices, e.g., airfares, intra- and inter-city transportation, delivery services and more.  The impact of higher oil prices, in particular, can lift the prices of a broad range of goods and services.  Fear of renewed fighting in the Iran war after the midterm elections should keep oil prices up for at least the next few weeks.  Computer memory prices, in contrast, appear to be falling gradually -- a good sign that the shortage is abating. 

AI is typically viewed as leading to higher productivity growth -- which would hold down inflation.  However, in the current early stage of AI adoption, firms may be using AI without reducing headcount.  They may be introducing AI cautiously.  With AI costly to use, it may be a factor lifting prices for now, as it may not be being offset by lower wages for some companies.  To be sure, AI could be a factor behind the recent slowdown in wage inflation.  (Average Hourly Earnings slowed to an annualized 2.4% in Q326 from 3.3% in the prior 4 quarters.)  With companies pulling back on hiring, either because AI substituted for labor or because of uncertainty about how AI will affect their need for workers, the ensuing weaker labor demand could be weighing on wage inflation.

One troubling speedup in the September CPI, not directly impacted by the non-economic factors, was Owners' Equivalent Rent (OER), which has a high weight in the CPI.  It reverted back to trend, rising 0.3% m/m in September after slowing to 0.2% in August.  The Core CPI would have rounded to 0.2% in September if OER rose only 0.2% and Lodging Away From Home was flat.  The trend in OER needs to slow to 0.1-0.2% for the Fed to achieve its 2% inflation target on a sustained basis.  If it does not, other prices need to slow below an annualized 2% pace to achieve the Fed's target -- arguing for more aggressive Fed tightening that would weaken economic activity.  To be sure, Primary and Owners' Equivalent Rent could be affected indirectly by oil prices to the extent that the latter is behind the rise in longer-term yields including mortgages.  A shift away from home ownership to renting as a result of the higher mortgage rates could put upward pressure on rents.  An end of the Iran war could lead to lower rents that help to hold down the CPI.

From the Fed's perspective, what's most important is preventing higher oil prices, because of their pervasive impact, from sparking a wage-price spiral.  This consequence does not appear imminent, despite the recent rise in inflation expectations, as wage inflation looks to be contained if not slowing.  So, the Fed can afford to skip hiking rates at the October FOMC Meeting if it wants and then resume tightening gradually at subsequent Meetings.