The Fed Cautiously Optimistic About Cooling Inflation, but Risks Remain

The Federal Reserve (the Fed) has expressed general satisfaction with the recent cooling of inflation in the U.S. economy. Inflation rates, as measured by the Consumer Price Index (CPI), have gradually declined throughout 2023. Nonetheless, there are risks that could affect its trajectory moving forward, especially in sectors such as housing, services, and energy.

The Headline CPI, which includes all goods and services, started the year with an annual rate of over 6%, but has now dipped below 4% as of September. The Core CPI, which excludes food and energy prices, has also shown a downward trend, although at a slower pace.

Upcoming data releases will provide further insights into inflation trends for the rest of 2023. The CPI releases for October and November will be closely watched, with the Wholesale Producer Price Index data coming shortly after. Additionally, the Personal Consumption Expenditure Price Index, which is the Fed's preferred metric for inflation, will be released as part of the November and December reports.

Recent nowcasts from the Cleveland Federal Reserve suggest a potential further cooling of headline inflation due to a drop in energy prices. However, core inflation, which excludes energy and food, may remain relatively stable at 4.1% compared to September. This could be a concern for the Fed, which aims to achieve its 2% annual inflation goal. If inflation continues to hover above 2%, the Fed may consider raising interest rates in December or January.

Housing trends will play a significant role in shaping inflation's trajectory over the coming months. As housing costs, including mortgages and rentals, account for a significant portion of household expenses, any changes in this sector will be reflected in inflation calculations. While shelter cost inflation has eased with rising mortgage rates, home prices have been on the rise since spring due to reduced supply. This could potentially reverse the trend of housing disinflation and contribute to overall inflationary pressures.

Wage growth has also slowed down in recent months, which should help moderate prices for services. However, wage growth remains relatively high, standing at over 5% for September 2023. This suggests that services inflation may continue to ease, but it is uncertain whether this level of wage growth will be sufficient to bring overall inflation closer to the Fed's target of 2%.

The main question that remains is whether inflation will swiftly return to the Fed's desired 2% target or if it will remain at a higher level for an extended period. Some economists argue that unexpected economic shocks could push inflation up further from its current levels. While 2023 has seen a marked decrease in aggregate inflation, the trajectory towards the end of the year remains uncertain and will depend on developments in the housing market.

The Fed will closely monitor these factors. If inflation fails to make significant progress towards the 2% goal, there is a possibility of further interest rate increases, although the expectation is for the Fed to keep rates steady in November.