Investors got some disappointing news on Thursday morning after one popular measure of U.S. consumer prices came in higher than expected in September.
The Labor Department reported the Consumer Price Index (CPI) rose 3.7% year-over-year in September, in-line with its 3.7% year-over-year gain in August and above the 3.6% growth economists were expecting. On a monthly basis, the CPI was up 0.4% compared to August, above economist estimates of a 0.3% gain.
The CPI reading is the latest indicator that inflation may be stickier than anticipated after hitting 40-year highs in 2022, and investors are debating whether or not the Federal Reserve will need to raise interest rates at least one more time in its current tightening cycle.
The S&P 500 initially gained less than 1% on Thursday morning following the discouraging September inflation report.
The Numbers
CPI growth hit a 2022 peak of 9.1%, but it trended lower at a somewhat steady pace in the first half of 2023. Year-over-year CPI growth dropped to a two-year low of just 3% in June before ticking slightly higher in July and August.
Core inflation, which excludes volatile food and energy prices, was up 0.3% on a monthly basis in September and 4.1% from a year ago.
Food prices were up 0.2% month-over-month and up 3.7% compared to a year ago. Energy prices were up 1.5% on a monthly basis but are down 0.5% over the past 12 months. Shelter prices were up 0.6% compared to August and 7.2% compared to September 2022.
The latest CPI numbers come after the Labor Department reported the U.S. economy added 336,000 jobs in September, nearly double economist expectations of 170,000 new jobs. The Labor Department reported U.S. wages were up 4.2% year-over-year in September, but rising prices are preventing many Americans from getting more mileage out of their growing paychecks.
In late September, the Commerce Department reported the core personal consumption expenditures (PCE) price index was up 3.9% in August, a slightly slower pace than its 4.3% year-over-year gain in July. Core PCE is the Federal Reserve’s preferred inflation measure.
Why CPI Matters
Inflation has been the Fed’s economic enemy number one for the past two years, and the Federal Open Market Committee (FOMC) has made aggressive changes to U.S. monetary policy in an attempt to bring inflation down toward its long-term target of just 2%.
The September CPI number likely increases the chances the FOMC will seriously consider an additional rate hike at its upcoming meeting that concludes on November 1. In its September policy statement, the FOMC said additional policy tightening “may be appropriate” to reach its 2% inflation goal.
In July, the FOMC raised its target fed funds interest rate by 25 basis points (bps), its eleventh interest rate hike since March 2022. The Fed is also allowing up to $60 billion in Treasury securities and $35 billion in agency mortgage-backed securities (MBS) to mature and roll off its more than $8.6 trillion balance sheet per month.
Nigel Green, founder and CEO of deVere Group, says the latest CPI report is yet another sign interest rates will likely remain elevated for an extended period of time.
“Taking into account the latest U.S. CPI data and the minutes from the most recent Federal Reserve meeting, which were published on Monday, we expect there to be one last 25 basis point hike at its two-day meeting beginning October 31,” Green says.
“The Fed will be conscious of growing uncertainty of the trajectory of the world’s largest economy and the risks of overtightening—especially in times of growing geopolitical uncertainty; while at the same time, want to avoid complacency in the continuing battle against inflation.”
According to CME Group, markets are currently pricing in an 89.3% chance the Fed will maintain its target fed funds rate range at its current level of between 5.25% and 5.5% at its next meeting. The market is also pricing in a 38.7% chance the Fed will issue another rate hike by the end of the year.
The Federal Reserve is navigating a difficult balancing act of raising interest rates aggressively to bring down inflation without triggering a U.S. recession. Rising interest rates increase borrowing costs for companies and consumers, weighing on economic activity. Up to this point, the U.S. labor market has been solid, but the New York Fed’s recession probability model suggests there’s a 56.2% chance of a U.S. recession within the next 12 months.
The odds of another Fed rate hike may have decreased in recent weeks as yields on long-term U.S. Treasury bonds jumped. Fed Vice Chair Philip Jefferson said in October that tightening financial conditions and higher bond yields mean the FOMC should “proceed carefully” at its upcoming policy meetings.
Other Factors Affecting Inflation
The recent outbreak of violence in Israel could also be a wildcard in the Fed’s battle against inflation, triggering higher fuel prices but also potentially weighing on global consumer sentiment and economic growth.
Gina Bolvin, president of Bolvin Wealth Management Group, says the hot CPI reading will likely not be enough for the Fed to pull the trigger on a November rate hike.
“The CPI headline is hotter than expected, but the surge in yields, rising gas prices and terrorist attack on Israel will allow the Fed—and the market–to tolerate this data. I think they will pause in November,” Bolvin says.
Growth stocks are particularly sensitive to interest rates because fund managers typically use discounted cash flow models to determine their price targets for growth stocks. Future cash flows are considered less valuable when the discounted rate is higher.
Higher interest rates also hit the high-growth technology sector particularly hard. The Technology Select Sector SPDR Fund (XLK) is down 2% since the beginning of 2022 but has rallied 36% so far in 2023 as inflation headwinds have faded.
What’s Next?
Third-quarter earnings season kicks into full swing on October 13 with earnings reports from big banks JPMorgan Chase (JPM), Wells Fargo (WFC) and Citigroup (C).
Analysts are projecting S&P 500 earnings will decline 0.3% in the third quarter, which could potentially mark the index’s fourth consecutive quarter of negative earnings growth. Fortunately, analysts are expecting S&P 500 earnings growth to bounce back into positive territory in the fourth quarter.
James Demmert, chief investment officer at Main Street Research, says the upcoming third-quarter earnings season will give investors an important update about the health of the economy. He says he expects generally positive reports, particularly from the technology sector.
“We view the recent stock market correction as a great window of opportunity for investors. The broader market trades at a price-to-earnings earnings ratio of less than 14, which makes for a compelling case for equities and in fact, a P/E ratio of this level is consistent historically with the start of bull markets,” Demmert says.
Main Street is also bullish on telecommunications, energy, healthcare, industrials and materials stocks this earnings season.
Investors will get another key inflation update when the Bureau of Economic Analysis releases its September core PCE reading on October 27.
In addition to a possible interest rate hike, investors will be monitoring the Federal Reserve’s commentary at its upcoming meeting that concludes on November 1. Investors will be paying particularly close attention to any changes in the language the FOMC uses in its policy statement regarding the economy and the outlook for interest rates.
