US inflation bounces to 3.7% in August, raising chances of rate hike

14 Sep 2023 , 10:31 AM

This also makes it very likely that the Fed will hike rates in its November Fed meeting while maintaining a pause in its September FOMC meeting. Of course, one can argue that the Fed is driven by PCE inflation and not so much by consumer inflation, but the experience in the last few months has been that these two measures of inflation tend to move in tandem for most part. 

Things appear to have changed a lot since June 2023. It was in June 2023 that the US inflation had touched 28-month low of 3%. Since then, the one factor that has driven up inflation in the US is the sharp spike in oil prices as the waning away of the high base effect. Even for the month of August 2023, the food inflation and core inflation are lower compared to July, but the pressure has come entirely from energy inflation. 

Will August inflation reading, impact the Fed stance?

One thing that cannot be denied is that the spate of rate cuts has certainly helped the US economy to contain inflation. Despite the bounce in inflation in the last 2 months, the headline inflation is still a good 540 basis points below the peak level of inflation at 9.1% scaled in June 2022. In short, the 525 bps rate hike by the Fed since March 2022 has surely had a deep impact in containing inflation. It is in this background that the Fed will deliberate on the future course of action. 

In a recent interview, Bob Michele (CIO of JP Morgan Fixed Income Group) had taken a contrarian view that the Fed may be forced to cut rates by the end of 2023, considering the high probability of a recession in the US economy. Clearly, the persistent hawkishness of the Fed has resulted in a structural slowdown in consumer spending and in the overall GDP. However, while the GDP numbers in recent quarters have shown signs of pressure, there has been little evidence of a full-fledged recession.

For the Fed, it will be a delicate decision on rates between the September and the November Fed meetings. It may be recollected that the Fed had paused on its rate hike journey in June 2023, but in late July, it had once again raised its benchmark Fed rates by 25 bps. The sharp fall in inflation in June 2023 to the 3% mark had not induced the Fed to pause in its July 26, 2023 policy meet. 

While there have been some words of caution about a likely economic slowdown, the broad consensus of the FOMC members (including Jerome Powell) appears to be that more rate hikes would be needed. Whether the Fed hikes rates in September or in the November 2023 FOMC meet, would be a pragmatic decision by the Fed. But the spike in inflation in August 2023 underlines the fact that the Fed is not done with rate hikes. It needs more ammunition to subdue inflation to the targeted 2% levels. 

Second inflation spike after 11 consecutive months of fall

The overall fall in US inflation from the peak in June 2022 is still very impressive at 540 bps in response to a 525 bps spike in interest rates. With the headline inflation spiking by 50 bps to 3.70%, the Fed would be worried that it has now moved 70 bps farther away from its 2% inflation target in the last 2 months. However, the Fed would also take consolation from the fact that this is purely driven by oil prices; even as food and core inflation is trending lower. The two recent months of spike in inflation may once again induce the Fed members to believe that the lag effect of rate hikes can do the job only to an extent. 

Beyond that, the FOMC still needs to set the inflation agenda with rate hikes. Since the peak of inflation at 9.2% in June 2022, the glide path if impressive. Consumer inflation fell to 8.5%, 8.4%, 8.2%, 7.7%, 7.1%, 6.5%, 6.4%, 6.0%, 5.0%, 4.9%, 4.0%, and 3.0% between July 2022 and June 2023. However, this trend has been partially arrested with the inflation spiking by 70 bps in July and August 2023. However, the one factor that would work on the minds of the FOMC members in September is that the higher inflation has been entirely driven by fuel inflation even as food inflation is down by 60 bps over July 2023 and core inflation is down 40 bps.

Food and core inflation lower; energy prices harden in August

The latest inflation spike, led by fuel prices, raises the spectre of rate hikes once again. The question is whether Fed would front end the hike in September, or wait till November 2023.

Inflation Basket Category	Aug 2023 (YOY)	Jul 2023 (YOY)	Inflation Basket Category	Aug 2023 (YOY)	Jul 2023 (YOY)
Food Inflation	4.30%	4.90%	Core Inflation	4.30%	4.70%
Food at home	3.00%	3.60%	Commodities less food and energy	0.20%	0.80%
Cereals and bakery products	6.00%	7.00%	Apparel	3.10%	3.20%
Meats, poultry, fish, and eggs	0.00%	-0.20%	New vehicles	2.90%	3.50%
Dairy and related products	0.30%	1.30%	Used cars and trucks	-6.60%	-5.60%
Fruits and vegetables	2.10%	2.90%	Medical care commodities	4.50%	4.10%
Non-alcoholic beverages	4.80%	5.40%	Alcoholic beverages	3.70%	4.10%
Other food at home	4.50%	5.40%	Tobacco and smoking products	5.60%	6.10%
Food away from home	6.50%	7.10%	Services less energy services	5.90%	6.10%
Full service meals and snacks	6.70%	5.80%	Shelter	7.30%	7.70%
Limited service meals	5.20%	7.10%	Rent of primary residence	7.80%	8.80%
Energy Inflation	-3.60%	-12.50%	Owners’ equivalent rent	7.30%	7.70%
Energy commodities	-4.20%	-20.30%	Medical Care Services	-2.10%	-1.50%
Fuel oil	-14.80%	-26.50%	Physician Services	0.30%	0.40%
Gasoline (all types)	-3.30%	-19.90%	Hospital Services	3.00%	3.10%
Energy services	-2.70%	-1.10%	Transport Services	10.30%	9.00%
Electricity	2.10%	3.00%	Motor vehicle Maintenance	12.00%	12.70%
Natural gas (piped)	-16.50%	-13.70%	Motor vehicle insurance	19.10%	17.80%
Headline Consumer Inflation	3.70%	3.20%	Airline Fare	-13.30%	-18.60%

Data Source: US Bureau of Labour Statistics

The above food basket would be key to the decision by the Fed. It now looks like another rate hike of 25 bps this year is inevitable. The only question is whether the Fed will wait till November or implement the rate hike in September itself. Here are some key takeaways from the data sheet above.

• Food inflation is down 60 bps from 4.90% to 4.30% over the previous month. If you look at the components of the food basket, inflation has fallen across the board on a yoy basis, especially in the cereals and dairy products basket. However, meat and poultry products have seen slightly higher inflation in August.

   

• The real action is in the energy basket, although the overall energy inflation is still in negative. However, between July and August 2023, the energy inflation has hardened from -12.50% to -3.60%, representing an 890 bps hardening of energy prices. However, electricity and piped gas have seen tapering of inflation in August.

   

• Core inflation has eased by 40 bps to 4.30%, although it could have been lower, but for the effect of the externalities of oil. In the core inflation basket, it is transport inflation that has gone up, even though most of the other items of core basket are down. The Fed actually would be targeting core inflation tapering to 2-3% on a sustainable basis.

MOM inflation spikes sharply to 0.6% in August 2023

The US Bureau of Labour Statistics (BLS) reports inflation on yoy basis, as well as on MOM high frequency basis. After touching a high of 1.2% in June 2022, MOM inflation stayed below 1% all through. Between July 2023 and August 2023, the MOM (high frequency) inflation has spiked from 0.2% to 0.6%, hinting at intense short term pressures on inflation. The August MOM inflation is the highest level in the last one year.

Here are some of the key takeaways from the MOM inflation data for August 2023.

1. MOM food inflation in August 2023 rose at a flat 0.2%. A total of 3 out of the 6 store food categories saw higher inflation viz. cereals, meat, and dairy products. MOM inflation in the food basket was lower for fruits & vegetables, non-alcoholic beverages, and other food items.

    

2. Energy index rose a whopping 5.6% MOM in August 2023 as energy commodities like gasoline and motor fuel rose in double digits. Downward pressure is seen coming in from electricity and piped gas usage, where prices are flat to lower.

    

3. Core inflation growth was slightly higher at 0.3% MOM in August 2023.  The pressure comes from airline fares, motor insurance and transportation, where the inflation pressure is a downstream derivative of higher oil prices. Other items in the core basket were flat to lower in August 2023.

What does US inflation reading, mean for the RBI?

How will the RBI and the Indian policy makers react to the latest inflation data from the US. As we had underlined earlier, the Fed uses PCE inflation rather than consumer inflation as the benchmark, but they are generally in tandem. Hence, for the RBI, this will be a key input as it grapples with rising inflation in India too. Indian inflation had gone up to 7.44% in July 2023, but has slightly tapered to 6.83% in August 2023. However, it still remains well above the RBI upper tolerance limit of 6% inflation. Remember, we are talking about the upper tolerance limit and the median inflation target is much lower at 4%. 

For the RBI, the latest inflation number in the US at 3.70% raises a piquant question. India has kept rates static at 6.5% since February 2023, despite the spike in inflation in the last 3 months. In the meantime, the US has continued to hike rates, except for the singular pause in June 2023. For the RBI, the challenge is not just to manage price stability but also to manage inflation expectations. Indian inflation expectations have been reined in the past, when the RBI has stood up to subdue inflation by making money dearer. The spike in US inflation makes another rate hike imminent. If the Fed chooses to hike rates in September instead of waiting till November, it is likely to add to the pressure on the RBI.

What the RBI would be perfectly wary of is that FPI flows have dwindled after a deluge between May and July. In September FPI have turned net sellers. That is largely due to the risk-off shift of capital and Indian real rates starting to get unattractive with respect to the US rates. Last month, we had written about the need for the RBI to have a Plan-B in place. Rising rates in the US amidst low inflation and static rates in India amidst rising inflation; is not a very healthy combination. The RBI is, obviously, conscious of the risks of such a dichotomy. How the RBI and the policy makers interpret this data points, hold the key.