"Federal Reserve's megaphone": Inflation remains strong, but not enough to disrupt the Federal Reserve's rate cut plan in December

In October, consumer prices saw a slight rebound after recording the slowest growth in three and a half years last month, indicating that inflation continues to decline on an uneven and rocky path. The latest report may not be enough to prevent the Federal Reserve from cutting interest rates again in December. However, combined with robust consumer spending and stable hiring, the strengthening of inflation may spark a larger debate among officials at their next meeting—discussing whether to slow the pace of rate cuts early next year.

The U.S. Department of Labor reported on Wednesday that consumer prices rose 2.6% year-on-year in October. This marks a rebound compared to last month, when the consumer price index increased by 2.4%. Core prices, excluding food and energy, rose by 3.3%. Both results were in line with economists' expectations surveyed by The Wall Street Journal.

Investors have been preparing for inflation readings to exceed consensus expectations, viewing Wednesday's report as good news. Traders increased their bets that Federal Reserve officials would cut rates by 25 basis points at their next meeting in December, rather than holding steady.

The positive reaction from investors to this report may partly stem from relief that President-elect Trump and the Federal Reserve will not immediately clash. Trump has repeatedly called for lower interest rates during his first term. Economists believe that some of the policies proposed by Trump, such as raising tariffs, could push inflation higher.

This is the first report after the U.S. elections. During Biden's administration, Americans have been disappointed with inflation, as current consumer prices are about 20% higher than when he took office. Voters around the world have punished leaders and ruling parties for high prices and inflation.

Although inflation has shown signs of cooling, it coincides with a delicate period for the economy when Trump took office, and the Federal Reserve's goal is to lower interest rates to ensure sustainable economic growth without reigniting inflation.

Strategists at Evercore ISI noted on Wednesday: “The inflation data is somewhat hot, which may lead the market to become less optimistic about Trump's reflation policies.”

Part of the overall increase in inflation is due to a more severe comparison with the same period last year. However, some items saw significant price increases last month. For example, the prices of used cars and trucks rose 2.7% seasonally adjusted from last month, while airfare prices increased by 3.2%.

Despite a decline in gasoline prices, energy prices remained flat compared to a month ago. This is because the drop in gasoline prices was offset by rising electricity and natural gas prices. Seasonally adjusted, overall prices grew by 0.2% month-on-month in October. Core prices rose by 0.3%. These results also met expectations. Before the inflation report was released, futures markets indicated about a 60% chance that the Federal Reserve would cut rates at next month's meeting. After the report was published, that probability rose to around 80%.

Despite some bumps along the way, inflation still appears to be on a cooling trend. In October 2023, overall consumer prices rose 3.2% year-on-year. In June 2022, prices rose 9.1% year-on-year, the most severe inflation since the early 1980s In addition, there is still a certain degree of "catch-up inflation" in the data. For example, auto insurance companies must negotiate with state regulators over price increases, so the surge in their costs takes time to be reflected in prices.

At last week's press conference, Federal Reserve Chairman Jerome Powell hinted that the Fed is prepared to respond to readings that are stronger than expected or "bumps." However, he believes that some of the residual stickiness in prices reflects the lagging effects of previous increases rather than new sources of price pressure. For instance, in the Consumer Price Index, rent increases continue to remain at historically high levels, but the rent increases for new leases have been quite moderate for over a year.

"This is just a catch-up issue. It does not really reflect current inflation pressures. It reflects past inflation pressures. Clearly, we are not declaring victory, but we feel that this is very consistent with the notion that inflation continues to decline on a bumpy road," Powell said.

If Fed officials continue to cut rates in December, then the focus may shift to the reasons that would prompt them to slow the pace of rate cuts next year. Several officials indicated on Wednesday that they want to avoid lowering rates too much to prevent being forced to reverse policy again.

Most of them believe that the current short-term interest rate levels are restrictive, which means that without further rate cuts, the labor market may cool further, even putting the economy at risk of recession.

Officials want to bring rates back to a more "neutral" level, one that neither stimulates economic growth nor slows it down, but they do not know where that level is. Before the 2008-09 financial crisis, many believed that the neutral rate might be around 4%, but after the crisis, the economic recovery was extremely slow, and economists and Fed officials believe that the neutral rate may be closer to 2%.

St. Louis Fed President Alberto Musalem told reporters on Wednesday that the Fed may gradually lower rates to neutral levels. He said, "The strength of the economy may provide room for a gradual easing of policy without rushing to find the neutral rate."

Dallas Fed President Lorie Logan stated in a speech on Wednesday that she expects more rate cuts will be necessary, but she also noted that there are some indications that the Fed may be approaching the neutral rate, which has risen in recent years.

She compared the Fed's work to that of a captain, who must avoid mistaking water for mud as the ship approaches shore. She said, "In these uncertain but possibly shallow waters, I think it's best to proceed with caution."