Inflation remained elevated in September – does it matter? The Consumer Price Index (CPI), one of the Fed’s favorite inflation gauges, rose 5.4% YoY in September, up from August’s 5.3%, as global supply chains remain disrupted. Headline CPI has now been above 5% YoY for five months in a row. It’s been more than three decades since that happened, the longest such gap in the history of the official data. Food, shelter, and energy price increases all contributed to the uptick in the index. Fun fact: The recent spike in the cost of living resulted in the US Social Security Administration announcing that monthly payouts to retirees and other beneficiaries will rise 5.9% in 2022, the largest such adjustment in 40 years.

Our take: While inflation pressures are likely to ease once logistical logjams resulting from the pandemic are unraveled, what worries markets is that the process is taking longer than expected, with no timely resolution in view. Despite the persistent rise in prices, and the financial media’s incessant coverage of them, what the Fed is really watching is inflation expectations – when and if households and firms consciously alter their behaviors in response to current and expected price dynamics. So far, it seems that inflation expectations haven’t changed (see the section on retail sales below), giving the Fed more freedom to respond than the financial news media would like to allow.

What caught our eye in the CPI data, and in the Fed meeting minutes also released last week, were signals that rapid growth in housing prices over the past year are flashing brighter on the Fed’s inflation radar screen. The minutes showed that Fed members flagged shelter costs in their consumer price basket as a key indicator to watch, likely as a sign that inflation is becoming less transitory and more persistent. Supporting the Fed’s heightened inflation concern was detail in September’s CPI data showing that rents, which typically lag housing prices by months, drove the bulk of the acceleration in core inflation last month. With housing prices up 20% over the past year, the pressure on rents will likely continue in future CPI releases. Hence, housing costs – not the price of gasoline or used cars – may turn out to be the most decisive factor in the debate over whether inflation is “transitory” as the Fed claims, or not.

Retail Sales data imply a turbulent holiday season. The data, which measures America’s economic health via its growth engine – consumer’s appetite for spending –  advanced 0.7% in September, much stronger than the 0.2% drop estimated by the consensus. The prior month was revised to a 0.9% gain, up from 0.7%.

Our take: The data show that consumers are shrugging off persistently high inflation, implying that inflation expectations – again, what the Fed is really watching – didn’t change in September. However, high prices and persistent product shortages into the holidays threaten to restrain consumers’ glee into year-end. The missing ingredient to make it all better? Clearing port backlogs. Given labor shortages up and down supply chains, that’s maybe a stretch…or maybe not.

Fed gave the world a peek into its tapering plans. Further, on the Fed meeting minutes released last week, the Fed outlined its plan to taper its purchases of Treasuries by $10 billion per month and mortgaged-backed securities by $5 billion, winding down the asset purchase program by next summer. Of course, the Fed could adjust the pace of the moderation of its purchases if economic developments differ substantially from what they expect. Given that everyone expects the Fed to kick off tapering by the end of the year – and since tapering doesn’t equate to hiking interest rates – the news had little impact on Treasury yields, LIBOR or SOFR. We suspect we’ll see tapering for sure in December but possibly as early as next month, during the Fed’s next meeting on November 2-3^rd.

The updated quarterly projections contained in the FOMC meeting minutes showed that Fed officials are now evenly split on whether it will hike rates as soon as next year. We suspect that if a hike did come next year, it would be in Q4. Interest rate markets don’t agree with us though, as they’re currently pricing in an almost one-in-two chance that the Fed will pull the trigger on its first quarter-point hike in June 2022, right about the same time that the Fed taper is ending.