What was in the September CPI report?

Inflation has been a dominant theme for markets all during 2022, and based on the September Consumer Price Index (CPI) report, it is likely to remain a dominant theme for some time to come. 

The report showed that consumer prices have risen by 8.2% over the last year, which is off the peak of 9.1% in June. However, so-called “Core” inflation—which strips out food and energy prices— hit a new peak at 6.6%. 

Here’s what this will mean for the Federal Reserve, investment markets, and your portfolio.

Goods prices seem to be slowing

The report showed that while overall inflation remains frustratingly high, the underlying details are mixed. 

Gas prices have declined substantially from their summer highs, so overall energy inflation declined by 2.1% this month. 

Excluding energy, overall goods inflation was unchanged in September. By “goods,” we mean any non-food physical item you would buy in a store or online, such as clothes or electronics. 

Furniture, appliances, medicines, used cars, clothes, and footwear all declined in price outright, representing the largest set of declining prices in two years. Some other goods prices rose modestly, but the overall price of physical goods was unchanged for the month.

Shelter costs still rising

Two large categories offset the 0% goods inflation rate. 

They both fall under “shelter,” which comprises rent rates, and something called “owners’ equivalent rent” or OER. This is a somewhat complicated calculation meant to guess how much homeowners could rent their house for if they wanted to. The Labor Department came up with this measure in the 1980s to assign how much inflation was attributable to rising home prices. 

For September, both actual rent prices and this OER estimate rose 0.8%. Because the cost of your home or apartment is generally such a large percentage of your household budget, these get a large weight in the CPI. 

Combined, they represent about 31% of the whole CPI. For context, all goods, less food, and energy are only 21% of the CPI. Hence the fact that these two shelter categories are rising at such a fast clip is having an outsized effect on the total inflation estimate.

What does this mean looking forward?

We remain of the view that inflation is likely to be at or near a peak. 

Here's why:

• The rise in shelter inflation shown in the CPI reflects a lagged effect. 
• Goods prices likely seem to continue slowing. 

It has been widely reported that housing market activity has declined substantially for shelter costs. 

New home sales have declined 34% over the last year, and according to the S&P CoreLogic Case-Shiller, overall home prices declined in September—the first outright decline since 2012. 

The nature of the OER calculation means it will take some time before a weak housing market translates into the CPI, but it will inevitably.

Rent prices also look like they are set to decline. According to the apartment industry service provider, Rent, the average rental rate declined in August. 

If this trend continues, it too will take some time before it translates into the CPI calculation. But clearly—if new rentals are declining—it is only a matter of time before the CPI's rent component also declines.

For goods, there is strong evidence that this deflationary trend will continue. Leading up to this report, several companies have warned that their unsold inventories were building up.

This included Walmart, Target, FedEx, Nike, and others. The most recent reports on industrial activity confirmed this, with the Institute of Supply Management report suggesting that new order activity contracted in September. 

Typically that would occur because customers of manufacturers--- including retail stores---have more inventory than they want already and aren't ordering as much in new goods.

When stores have too much inventory, they generally mark down the excess to clear their shelves. We could be seeing this now, and this would explain why goods prices were unchanged to down in September. 

Additionally, if goods manufacturing slows down, it could alleviate supply-chain pressures that have been a source of inflation for the last two years.

What will the Federal Reserve do in response?

The Fed can’t be happy about this CPI report. 

In the Fed’s September meeting minutes released on October 12, several Fed officials expressed concern about the “risk of significant adverse effects on the economic outlook.” 

Meaning: The Fed sees signs that the economy is slowing

While the Fed remains committed to fighting inflation above all else, the risk of an economic slowdown is making them less comfortable. 

If we saw even modest signs that inflation is slowing, it could be enough for them to pause rate hikes sometime in the next few months.

The fact that Core CPI came in at a recent peak makes any immediate rate hike pause much more difficult. In fact, it will probably cement another 0.75% rate hike at the Fed’s November meeting. 

Beyond that, though, this CPI report itself may have that much influence. By the time the Fed meets in December, there will be two more CPI reports plus several other inflation indicators. 

So if some of the issues we discussed above start to weigh on the CPI in the next two months, it could result in a smaller Fed rate hike in December.

What this could mean for your portfolio

If inflation starts to slow from here, it would be good news for various reasons. 

One is simply the fact that high inflation has weighed on most people's budgets. However, it has also been a major driver of investment returns in 2022. 

If inflation starts to subside, it will remove a major worry for both stock and bond investors, and normally as worries subside, prices rise. 

While this CPI report was a disappointment in terms of the overall inflation number, the underlying details suggest that inflation pressure may already be waning.