Ladies and gentlemen, this is not what disinflation and a near-term return to the Federal Reserve’s 2% inflation target looks like.
The midsummer lull in inflation ended in August as prices jumped on higher energy and gasoline costs. The result was an increase in the Consumer Price Index of 0.4% on the month and 3.4% compared to a year ago.
Inside the core rate, inflation advanced by 0.3% on the month and 2.4% annually. Taken out to three digits on a monthly basis, the headline figure increased by 0.399% and the core by 0.290%.
Both figures point toward a rate hike when the Federal Reserve makes its policy decision on Sept. 16.
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The jump in headline prices came from the energy complex, airfares and transportation, all of which will increase at a quicker pace in the September data given the recent surge in oil, gas and diesel.
Policy implications
With higher oil and distillate prices set to be passed downstream to consumers, the Federal Reserve his little choice but to raise its policy rate at its next meeting.
The war-induced energy shock, tariffs and the AI build-out are all pushing prices higher.
But the usual course of action for the Fed is to wait out these kinds of supply shocks. So why not this time?
The three supply shocks have endured long enough that they are no longer appropriate to be identified as transitory.
The prices of distillates, including gasoline, diesel and jet fuel, are rising sharply and are not being absorbed by companies through margin compression.
Those price increases are showing up in items such as groceries and everything touched by transportation and deliveries that are at the core of the American service-based economy.
I want to be clear here that the Fed should not be chasing volatile energy prices. That is not why we think the Fed should and will hike rates at its next meeting.
Rather, the best monetary policy is forward-looking. What was thought to be a short-term conflict has, seven months later, turned into a protracted standoff, which now requires a rational policy response from the Federal Reserve.
The Fed needs to remove the three rate cuts that it implemented late last year and slow an economy that is likely to grow well above trend in the current quarter.
By almost any measure the economy is strong: Nominal GDP was above 6% in the second quarter, the deficit to GDP ratio is above 6%, the economy resides at or near full employment, and companies have reported record profits.
By slowing the economy down, the central bank will force those price increases that are now flooding into household balance sheets back on to corporate balance sheets via margin compression.
Granted, the decision on rates is a difficult one and is truly a coin flip now. But for the Fed not to hike rates at its next meeting would be a blow to its own credibility given comments by Fed Chair Kevin Warsh at Jackson Hole and other rhetoric by both hawks and doves across the central bank in its aftermath.
The data
For the past several months, we have made the case that service prices were stubborn and sticky. That continues to be the case as service inflation advanced by 0.3% in August and was up by 3.1% from one year ago.
Inside the energy complex, which increased by 2.1%, energy commodities were up by 4.2%, gasoline 3.9% and fuel oil 10.1%.
Transportation costs advanced by 1.2%, new vehicles 0.3%, used cars and trucks 0.4% and airline fares by 2.7%. Energy service costs increased by 4%, electricity prices rose by 3.8% and utility gas services increased by 4.4% from one year ago.
From a year ago, energy costs were up by 16.3%, energy commodities by 28% and gasoline by 27.4%.
Food costs advanced by 0.1% and were up by 2.7% from one year ago. One should anticipate that food prices will rise sharply in the coming months because of the rise in energy and transportation costs linked to the recent spike in oil, gasoline and diesel prices.
Housing costs increased by 0.2% as did owners’ equivalent rent. Shelter was up by 0.1%.
Apparel costs were flat during a month that typically sees price increases, so that is something that may be revised upward next month. Medical costs declined, recreation was flat, education and communication prices jumped by 1.6% while commodities increased by 0.6%.
The takeaway
Following a brief easing in June and July, inflation surged again in August, which sets the stage for a likely interest rate hike by the Federal Reserve at its September policy meeting.
Energy, transportation and service prices led the way and each of them is likely to rise further, in some cases sharply, because of the spike in oil and distillate costs that will ultimately show up in higher food costs.
We expect the Fed to raise its policy rate by 25 basis points at its meeting followed by at least two more hikes over the next year to put inflation on a credible path back to the central bank’s 2% target.
While we think it is a close call given the pricing dynamics in the August report, the Fed needs to hike rates to retain its own credibility.
