Inflation report could show CPI moderating as gas, travel costs fall

Inflation is still very strong but is expected to have moderated in August as gas prices fell, supply chains improved and the cost of travel fell.

The consumer price index is due out at 8:30 a.m. ET on Tuesday, and the report could be a little messy, as headline inflation is expected to fall while core inflation, excluding energy and food, should increase. The report is also key because it is expected to influence the Federal Reserve’s decision on how much to raise interest rates next week, and more importantly, over the longer term.

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The all-items CPI is expected to have declined 0.1% month-on-month in August, after a flat reading in July, according to Dow Jones. On an annual basis, the headline CPI would remain at a pace of 8%, down from 8.5% in July.

But excluding gasoline, core CPI is expected to rise 0.3%, the same as in July. On a year-over-year basis, that would be a 6% increase, even warmer than the 5.9% gain that month.

For the Fed, the report is expected to confirm that it must continue its fight against inflation with an interest rate hike next week of 0.75 percentage points, the third in a row of this size. If the inflation data is weaker than expected, some economists say there is an outside chance the Fed could hike by just half a percent.

“If anything, the risk is that it could be a bit weaker,” said Aneta Markowska, chief economist at Jefferies. “I have energy commodities down 10.2%. That should lose half a percent. I think core will be more important.”

Gasoline prices are the main driver of the energy decline. Since hitting a high of $5.01 in mid-June, the national average for unleaded gas has fallen throughout the summer, to an average of $3.71 a gallon on Monday, according to AAA.

Markowska expects the overall CPI to decline by 0.2%, but sees a core increase of 0.3%. Refuge is one area expected to rise, while used car prices are expected to fall.

“I think we’re going to see a repeat in terms of airfares and hotel prices. They dragged down the core CPI last month. It looks like airfares are going to be down 8%,” Markowska said. “They were up 40% from March to May. We’re only relaxing some of that.”

Economists say the core effects of comparing the figure with last year are behind the jump in core inflation in August.

“Due to core effects, annual core inflation is likely to accelerate in the next two reports, which would make Fed policymakers uncomfortable,” wrote Blerina Uruci, chief U.S. economist at T. Rowe Price. He said it shouldn’t matter to central bank officials because they will be more focused on momentum and will be watching the three-month and six-month annualized pace.

“But they are also sensitive to how it will look to the public and Congress. All the more reason to maintain a hawkish approach,” he added.

Strategists say the Fed’s September 21 rate decision may be affected by the August CPI report, but the details within that report may be more important in terms of what they say about the long-term prospects. That could help shape expectations for the Fed’s final or terminal rate when it stops hiking.

Market expectations for the Fed’s terminal rate have steadily risen, and in the futures market the view is that it will reach 4% early next year. Markowska expects it could reach 4% to 4.25% in January.

“That’s where we start to look at whether there’s a change in the underlying patterns, where the Fed may or may not taper,” said Diane Swonk, chief economist at KPMG. She expects policymakers to raise the fed funds target range by 75 basis points next week. That would bring the fed funds target range to between 3% and 3.25%. One basis point is 0.01 percentage point.

“That leads them to a strict policy. Then it’s a question of how far they want to go,” Swonk said.

That’s a key question for the markets, as some professionals expect the Fed to stop at the end of the year. Others expect a pause early next year and some investors believe the central bank will start cutting interest rates in the second half of 2023.

Fed officials, led by Chairman Jerome Powell, have stressed they will raise rates and keep them there. However, the market is still betting that policymakers will not be as tough as their talks.

“I don’t think this report changes much for the Fed. I think the problem for the Fed is that even as inflation is slowing, growth momentum is coming back in part because oil prices ‘energy are lower,’ said Markowska. “That’s increasing purchasing power.”

He said consumers appear to be diverting money that had been intended to fuel their cars to other goods and services. That could keep the economy hotter than the Fed wants, and it now expects third-quarter growth of 3% or more.

“This is above-trend growth at a time when the Fed needs to engineer below-trend growth,” Markowska said.