A double whammy of strong data, but what will the Fed do next?

A pattern is emerging, US data continues to surprise on the upside. Last Friday it was September payrolls data, on Thursday it was stronger inflation. This is likely to push the Citi US economic surprise index further into positive territory, and it continues to add to the body of evidence that the US economy is heading for a soft landing. However, the key question for investors is what it means for the Federal Reserve, and for interest rates in the US.

Service sector inflation remains sticky

US inflation data failed to moderate last month as expected, and instead the headline rate remained steady at 3.7%. However, when it comes to inflation, it is worth digging beyond the headline figure to understand what is going on with deeper price growth trends. Core inflation, which strips out energy and food prices, moderated as expected to 4.1% from 4.3% in August. Prices that saw large increases include gasoline and shelter costs. Shelter prices were the largest upward contributor to the increase in monthly inflation. The Fed’s preferred inflation measure is the core personal consumption expenditures’ index, which is closer to the core CPI rate, thus it is important to look closely at core inflation to gauge the price trend.

Other sectors included in the core price index, which saw monthly increases in September included lodging away from home, car insurance, recreation, personal care, and new cars. Service inflation rose by 0.6% on the month, which is the largest increase for more than 6 months. One month’s worth of data does not make a trend, but the fact that the rise in service sector inflation last month was double the rate of growth in June is worth observing: is this a blip or a sign that service sector inflation is sticky, and could move higher in the coming months? This question matters, since the Federal Reserve is taking a meeting-by-meeting approach to policy making.

As rental costs soar, blame the Fed

Interestingly, the rise in shelter costs accounted for 70% of the increase in all core CPI last month, however it is hard to see what else the Federal Reserve can do to try and weigh on house price growth. They have raised interest rates at the fastest pace for decades, and home sales are slumping. New home sales fell by 8.7% in August, to the lowest level in 11 months. Pending home sales also fell 7.1% in August. While home sales might be slowing, it could push more people into renting. In contrast to home sales growth, rental costs rose by 0.71% on the month in August. Since February, there has been a strong upward trend in rental growth rates, which have averaged more than 0.9% growth per month. Over 3-years, US rents have risen by more than 18% on average, well above pre-pandemic norms. However, there are large regional variations in rental costs. The highest rate of rental growth is in the Northeast of the US and the West, the average rental price in the Northeast in August was just over $2,500 per month, this is $450 per month more than the US average. In contrast, average monthly rental costs in the Midwest are more than $1000 per month lower than the national average. However, rental costs in the Midwest have also risen sharply in recent months, and regionally, the Midwest experienced the highest annual rate of increase in August. At this stage, it is hard to see how or when shelter costs will start to moderate, and they are likely to continue to have a negative influence on inflation trends in the coming months.

Inflation: the market reaction

With the Federal Reserve and other central banks setting monetary policy based on the latest data points, they are particularly vulnerable to rogue data points or data revisions, so it is worth watching these closely. Without a clear vision of where monetary policy will go next, and if we have reached the peak for interest rates, the market reaction to economic data can be volatile. At the time of writing, the S&P 500 has reversed early losses, but is still up by more than 3% on the week, after news that the Chinese government could offer more stimulus to support their economy. The dollar has risen sharply across the board, and the dollar index is up by 0.5% at the time of writing. The 10-year yield is higher by 7 basis points on Thursday, reversing the 25 bp drop in 10-year yields in the past 5 days on the back of some dovish Federal Reserve commentary. The 2-year yield is also rising, but only by 5 basis points, which means that the US yield curve is continuing to bear steepen. This can be bad news for the economy, and from an economic perspective, rising yields will make mortgages less affordable, and could put further upward pressure on rental costs and thus inflation.

Interest rates: higher for longer

The stronger US inflation and payrolls data has pushed up expectations for another interest rate hike by the end of this year. The market is now expecting a near 37% chance of a rate hike to 5.5-5.75%, this is up from 26% last week. The higher for longer theory about US interest rates has also been boosted by the positive data surprises. There is now a 33% chance that interest rates will still be 5.25-5.5%, up from a 28% chance last week. If expectations for interest rates to remain elevated for the long term continue to creep higher, then we could see more stock market weakness as we lead up to some key earnings releases next week.