Core inflation shows no signs of relenting in U.S., raising odds of more big rate hikes

Inflation in the United States showed few signs of easing in September, reinforcing expectations that the Federal Reserve will deliver another oversized increase in interest rates next month and creating a political headache for the Biden administration ahead of key midterm elections.

The U.S. Labour Department said on Thursday that core consumer price inflation, which excludes volatile food and gasoline prices, hit an annual rate of 6.6 per cent last month, the fastest pace in four decades. This puts pressure on the Fed to keep increasing borrowing costs, even as the U.S. economy, and the global economy more broadly, slows down.

The strength and persistence of U.S. inflation is reverberating around the world. The Fed’s aggressive campaign to increase interest rates has made it more expensive to borrow money, while also pushing up the value of the U.S. dollar relative to other currencies, including the Canadian dollar, which increases the cost of U.S. imports.

Thursday’s strong inflation reading could put pressure on the Bank of Canada to continue raising interest rates to keep pace with the Fed. It also increases the odds of a global recession, as higher borrowing costs squeeze U.S. businesses and consumers, particularly in sectors that are interest-rate sensitive, such as housing.

High inflation has become a political liability for the Biden administration and the Democratic Party ahead of midterm elections on Nov. 8. Republicans have slammed their Democrat opponents on cost-of-living issues, drowning out their attempts to take credit for the country’s strong job market and rapid economic recovery from pandemic lows.

President Joe Biden acknowledged on Thursday that Americans are being squeezed by rising prices. “That’s been true for years, and they didn’t need today’s report to tell them that,” he said in a statement. Inflation is “still too high,” he said, but added that “everyday costs will go up – not down” if the Republicans take control of Congress.

Overall consumer price index inflation in the U.S. was 8.2 per cent last month, down slightly from 8.3 per cent in August and a four-decade high of 9.1 per cent in June.

“This is not what the Fed wants to see six months into one of the most aggressive tightening cycles in decades,” Bank of Montreal senior economist Sal Guatieri wrote in a note to clients.

The central bank has announced three consecutive hikes of 75 basis points, and forecasters now expect another 75-basis-point move in November, and further increases in December and early next year. A basis point is a hundredth of a percentage point.

The Fed – the world’s largest and most influential central bank – has turned increasingly hawkish in recent months in a bid to prevent high inflation from becoming entrenched and to shore up its credibility as an inflation-fighter.

Minutes from the central bank’s most recent rate decision, in September, show that officials are more concerned about doing too little to combat price increases than doing too much and causing a painful economic contraction.

“As the Fed continues with this very aggressive pace of interest-rate hikes, we think more weakness lies in store,” Andrew Hunter, senior U.S. economist with Capital Economics, said in a webcast on Thursday. “We now think the economy is headed for a recession over the coming quarters. We think it should be a relatively mild recession by past standards, but we are penciling in declines in GDP over the first half of next year.”

Stock markets responded to the inflation data with a wild swing. The S&P 500 index fell nearly 2 per cent when markets opened, but quickly rallied, finishing the day up 2.6 per cent. Meanwhile, the yield on two-year U.S. government Treasury bonds jumped more than 20 basis points at the open, hitting 4.5 per cent for the first time since 2007, before ending the day at 4.47 per cent.

The September data show the key drivers of U.S. inflation are shifting from goods to services. Energy prices were down 2.1 per cent that month, led by a 4.6-per-cent drop in gasoline prices. The cost of used cars, clothing and appliances also fell.

But this was offset by a rise in the price of food, medical care and shelter. Rental prices increased 0.8 per cent compared with August. Owners’ equivalent rent, a measure of housing costs for owner-occupied dwellings, also rose 0.8 per cent – the biggest monthly jump since June, 1990.

“The labor-intensive services sector continues to be the main driver behind the persistently high core inflation trends and as the labour market keeps up its strength there is no reason to see this abating in the near term,” Toronto-Dominion Bank analysts, including rate strategist Oscar Munoz, and head of global rates strategy Priya Misra, wrote in a note to clients.

“The only possible bright point is that core goods inflation was flat over the month in September after increasing in the preceding months. This might become negative over the coming months, somewhat counteracting against sticky high core services inflation.”

Last week, Bank of Canada governor Tiff Macklem said the strength of the U.S. dollar, and the Canadian dollar’s relative weakness, means the central bank may have to do more to bring down inflation. The Bank of Canada does not formally target exchange rates, but it does monitor them closely.

“Normally when we raise interest rates, the exchange rate actually appreciates. And so that does part of the work for us. This time, that’s not happening. So other things equal, as economists like to say, that means we have more to do with interest rates,” Mr. Macklem said.

Many analysts expect the Bank of Canada to announce another half-point interest-rate hike at its next rate decision, on Oct. 26.

Mr. Macklem will address reporters on Friday from Washington, where central bankers and finance officials are attending the annual meetings of the International Monetary Fund and World Bank.

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