Instant Insights: Core inflation remains stubborn | Insight Investment

US consumer prices rose 0.6% in September, taking headline CPI from 3.4% to 3.7% year-over-year. Core prices rose by 0.3%, pushing core CPI from 2.4% to 2.6%.

Energy prices drove headline CPI, while many core CPI categories trended sideways. However, with the Federal Reserve (Fed) keen to support a timely return of inflation to its 2% target, and core PCE running at hotter levels, rate hikes remain firmly on the agenda.

Energy continues to drive headline CPI

Energy prices rose 5.2% in September. This was driven by a 9.1% rise in gasoline prices, which alone accounted for over half the monthly increase in CPI.

Food prices were unchanged, with grocery prices (“food at home”) falling by 0.1%. Core goods prices rose 0.3%, with notable gains in used vehicles and apparel as well as recreation and education goods.

Figure 1: Energy prices continue to drive above-target headline inflation¹

The “stickier” core services components of CPI have generally reflected disinflationary trends in recent months, but moved sideways to slightly higher in September. However, we would need more evidence to consider it more than a temporary bump in the road. The longer global energy prices remain elevated nonetheless, the greater the risk of feedthrough to core inflation.

Shelter, the largest index component, accelerated from 3% to 3.2% year-over-year, interrupting its recent easing trend (Figure 2). Elsewhere, lodging away from home (which includes hotels) rose from 3.2% to 4.4% year-over-year.

“Supercore” services (which exclude the housing components of shelter), rose from 3% to 3.1% year-over-year. Transportation services rose from 2.5% to 2.7% year-over-year, partly reflecting an increase in car and truck rental prices in September.

Figure 2: Shelter prices continue to ease²

Core CPI is close to target, but the Fed is tied to a hotter inflation metric 

Historically, core CPI has tended to run ~0.3% to ~0.5% above the Fed’s preferred metric, core PCE. However, core PCE has been running uncharacteristically ahead of core CPI over recent months (Figure 2).

This partly reflects CPI’s higher weightings to shelter and auto insurance (which has cooled recently) and lower weightings to software and accessories and financial services fees and commissions (which have increased).

The Fed therefore finds itself unusually tied to the hotter metric, a distinction we expect may tilt it toward a more hawkish stance.

Figure 3: Core CPI has been moderating, but the Fed is tied to the uncharacteristically hotter metric³

The hiking cycle remains on the table, but market pricing may offer opportunity

The Fed has made clear its intention to support “timelier” return of inflation back to its 2% target. As such, we believe that stubborn core CPI keeps a potential rate hike in play later this month.

Our base case is for three additional rate hikes over the cycle, and market pricing already reflects at least three hikes over the next 12 months. In our view, the risks skew to fewer (rather than more) than three hikes overall, given risks to interest rate-sensitive sectors of the US economy.

We believe that US Treasuries look strategically attractive, and, based on how market momentum evolves, we believe it is a potentially attractive time to consider entry points for overweight duration positions in fixed income assets.