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US headline inflation fell from 3.7% to 3.2% YoY in October following a flat month-on-month reading. However, given the role of energy and base effects in the headline measure, the focus for markets remains on the core index, which was expected to produce another 0.3% MoM print due to strong momentum in services inflation, a mechanical boost from the new measurement of the health insurance component, and a positive residual factor.
Nevertheless, core inflation actually fell back to 0.2% MoM, with the unrounded figure dropping 10 basis points on the month to 0.23%. In conjunction with signs that drivers of services inflation were narrowing and likely to prove unsustainable, markets slashed any residual risk of a December rate hike from the Fed, while simultaneously bringing forward expectations of rate cuts – swap markets are now pricing in just a 2% probability of a December hike from 15% previously, while 37.5bps of cuts are priced in by June 2024 relative to 19bps prior.
Momentum in core inflation and core services inflation cools considerably at the start of Q4
It wasn’t just the decline in core inflation momentum that prompted this market reaction, the composition of the inflation report was also soft. Core goods inflation continued to contract, albeit at a slower pace of -0.1% MoM, while core services inflation also moderated from 0.57% to 0.33% MoM.
Within core services, inflation pressures narrowed. The bulk of inflation came once again from shelter, which contributed 0.197 percentage points. This reflected owners’ equivalent rent falling back only slightly from 0.56% to 0.41% in October and rent of primary residences remaining stable at 0.5% MoM. Outside of shelter, transportation services (0.05pp) and hospital services (0.02pp) provided the largest positive contributions, with the former boosted once again by motor vehicle insurance, which rose 1.9% MoM, and the latter benefitting from the new methodology for estimating health insurance, which produced 1.1% MoM growth. But even here, inflation is unlikely to continue tracking at these levels in the upcoming months.
Shelter inflation is steadily normalising, in line with the previous reduction in house prices.
Meanwhile, inflation in motor vehicle insurance is also set to moderate given components for car repairs are now in outright deflation, alongside new and used vehicle prices, while the impact of the recent health insurance re-estimation is set to smooth out too. Outside of these components, inflation pressures in services looked soft. Specifically, demand and wage sensitive categories saw moderate price growth, such as recreation services (down from 0.5% to 0.1% MoM), suggestive that the recent easing in the US labour market and more constrained discretionary incomes leading into the fourth quarter are starting to drag on price growth.
Given Chair Powell specifically outlined excess aggregate and labour demand as influential metrics in deciding whether to hike in December, it is unsurprising to see the market-implied odds of a final Fed rate hike collapse seeing as the components that best reflect these dynamics softened considerably at the start of the fourth quarter.
For markets, this was the outcome required for traders to resume pricing in earlier and more aggressive rate cuts from the Fed, pick-up Treasuries, and sell the dollar into year-end in a similar fashion to late-2022 back when core inflation first started to turn a corner. It is unsurprising to see European and high beta FX rally against the dollar as a result of the falling US rates, with both groups trading under considerable pressure for the last two-and-a-half months from the tighter US financial conditions. Within G10 FX, today’s soft inflation report has triggered GBP, EUR, NZD, AUD, NOK and SEK to rally over a percentage point against the dollar in the space of 30 minutes after the report.
Treasury yields and the dollar both nosedived following today’s CPI release
Author:
Simon Harvey, Head of FX Analysis