Inflation in September exceeded expectations, but it may not hinder a 25bp rate cut in November. After the unexpectedly strong non-farm payroll data in September, the risk of inflation has once again come into the market's view. The continued decline in energy prices in September has driven the overall inflation to continue to fall in September, but due to the impact of core inflation, the overall level of inflation is still higher than market expectations. Before the release of the inflation data, the expectation of a 50bp rate cut in November had already been erased due to the disturbance of employment data. After the inflation data in September exceeded expectations, it did not hit the expectation of a 25bp rate cut in November, and the probability of a 25bp rate cut even slightly increased.

The height of the second round of inflation in the United States may be limited. After the slight rise in core inflation in September, the U.S. market still has concerns about subsequent inflation, mainly from two sources: the first is the lagging effect of rents in the real estate sector on service inflation; the second is the secondary risk of goods inflation. We believe that given the weakness of core goods, the impact of rising commodity prices may be relatively small, and the greater impact is the influence of housing prices on housing rents. However, the rebound height of this housing rent lagging effect may not be high. Moreover, after reflecting the rebound of the recent round of housing prices, it may also fall again with the decline of housing prices. Therefore, even if the United States starts to show signs of rebound in inflation at the end of the year, the height of the rise may also be limited.

Advertisement

"Stability" may be a more prudent approach. After the September FOMC, the market expected the Federal Reserve to cut rates by another 50bp in November. At that time, we had already pointed out that the rate cut at the September meeting led to the market's "front-running" expectations for subsequent rate cuts. Now, the rate cut expectations have fallen back to a normal pace, which is also within our expectations. Federal Reserve officials said they are not worried about inflation accelerating again, but are more concerned about the harm to the labor market. The reason for this is that current monetary policy operations are more influenced by the labor market, and the height of U.S. inflation may be limited. Under the risk of a second round of inflation, we believe the Federal Reserve should be cautious in controlling the pace of rate cuts, and "stability" may be a more prudent approach.

Risk factors: geopolitical risks, international oil prices rising beyond expectations, the labor market weakening beyond expectations, etc.

Text

1. Inflation in September exceeded expectations and may not hinder a 25bp rate cut

After the unexpectedly strong non-farm payroll data in September, the risk of inflation has once again come into the market's view. Last week's non-farm payroll data showed that new employment far exceeded expectations, and at the same time, wage growth was also higher than expected. Under this background, the CPI in September is a key data.

After a 50bp rate cut in September, the recent strong non-farm data and the continued decline in inflation data have confused the market and even questioned the credibility of this inflation data. In fact, the performance of inflation shows that inflation resilience is still there.

First, although inflation continued to fall in September, the rate of decline was slower than expected by the market. For the U.S. inflation data in September, the market expected that the September inflation would fall to 2.3% year-on-year, and the expected core inflation was 3.2%. In fact, the overall CPI rose 2.4% year-on-year in September, and the core CPI rose 3.3% year-on-year. Although inflation is falling, the rate of decline is actually less than expected, and the core inflation performance is also higher than expected.

Second, unlike overall inflation, core CPI rose year-on-year. Since the inflation data announced last night was not seasonally adjusted, compared with the previous value of the same口径, the core CPI rose not only higher than expected but also higher than the previous value (3.2%). We believe that the final seasonally adjusted data, the core CPI may also be higher than the previous value year-on-year, which indicates that the rate of decline in inflation is slower than expected or more due to the rebound of core inflation.Thirdly, the overall inflation continued to slow down, mainly driven by the persistent decline in energy prices in September. The energy CPI in September was -6.8% year-on-year, down by 2.8 percentage points from August, while food inflation rebounded from 2.1% to 2.3%, and core inflation did not decrease; energy prices were the largest downward item in September inflation.

Therefore, the recent strong non-farm data combined with the decline in inflation seem to indicate that both employment and inflation are moving in the direction desired by the Federal Reserve. However, upon closer examination, the fact remains that inflation is still resilient.

The slower-than-expected pace of price decline, coupled with the strengthening labor data, has to some extent undermined the expectations for a rate cut by the Federal Reserve within this year, but it has not changed the expectation of a 25bp rate cut in November.

In fact, during the National Day holiday, after the release of the US non-farm data, the overseas probability of a 50bp rate cut in November has been erased, shifting to an expectation of a 25bp rate cut in November. After the September inflation data exceeded expectations, there was some disturbance to the expectations for a rate cut by the FOMC in December, but it did not reduce the expectation for a rate cut in November. Even the probability of a 25bp rate cut in November slightly increased.

II. The upward limit of the second round of inflation in the US may be limited

The pace of inflation decline in the US in September was less than market expectations, and core inflation slightly increased, with the US market still worried about subsequent inflation. According to the model of the Cleveland Fed, both CPI and core CPI in October are expected to rebound year-on-year. From a quarterly perspective, the performance in Q4 is also higher than in Q3, all of which reveal the risk of subsequent inflation in the US.

Concerns about the subsequent performance of US inflation, we believe the risks mainly come from two points:

The first point is the lagging effect of rents from the real estate sector on service inflation. Looking at core service inflation alone, core inflation is still about two percentage points away from the pre-pandemic trend. Among them, changes in housing prices are an important contributing item, and the current rebound in housing prices has not yet been reflected in service inflation in the form of a lagging effect on rental prices.

The second point is the secondary risk from commodity inflation. In the past process of inflation decline, both non-core items and core commodity items have played an indispensable role. However, under the rate cut transaction, the market is worried about a secondary inflation in commodities.

Given that core commodity prices are still weak, the impact of their price increase may be relatively small. Since the beginning of this year, US core commodity prices and core service prices have shown a divergent characteristic - core commodity deflation and core service inflation. However, in the September breakdown, the growth rate of core service prices continued to decline, while the growth rate of core commodity prices rebounded, breaking the price change trend since the beginning of the year. The narrowing of the decline in core commodity prices in September has sparked a rebound in core inflation, reigniting market concerns. However, looking at the composition of core commodities, the increase in core commodity prices in September was mainly due to the change in transportation goods (especially used cars) prices. The temporary price increase in transportation goods also occurred at the end of last year, and at that time, it did not affect the decline in core inflation. We believe that, given that core commodity inflation is still in a deflationary range and core service inflation has not yet rebounded, the impact of the rise in commodity prices may be relatively small.The more significant impact is the lagging effect of housing prices on rental rates, but the rebound height of this lagging effect on rental rates may not be high. Since housing prices typically lead rental prices by about 18 months, and the year-on-year rebound in U.S. housing prices began in June 2023, we project that the lagging effect of U.S. housing prices on rental rates might start to manifest around the end of this year. After a period of sustained rebound in the growth rate of housing prices, they have returned to a downward trend, and the height of the rebound in housing prices is also limited. We believe that the lagging effect on rental rates, which may begin at the end of this year, could lead to a rebound in inflation, but the overall height may not be significant. After reflecting the recent rebound in housing prices, it may also decline again following the fall in housing prices.

III. "Stability" May Be a More Prudent Approach

Looking ahead, the Federal Reserve's interest rate reduction pace may still be primarily focused on stability. After the September FOMC meeting, the market expected an additional reduction of 50 basis points. At that time, we had already pointed out that the interest rate cut at the September meeting led the market to "front-run" expectations for subsequent rate cuts. If the economy does not show a significant downturn, the subsequent rate reduction pace will be more focused on stability (25 basis points). The current reduction in rate cut expectations and the return to a normal pace are also within our expectations (see the previously published report "The Logic of a 50BP Rate Cut: The Beveridge Curve Returns to Normal").

Moreover, Federal Reserve Governor Daly has indicated that she is not worried about inflation accelerating again; she is more concerned about the damage to the labor market. We believe this is the case for two reasons. First, current monetary policy operations are more influenced by the job market, and expectations for the pace of rate cuts have significantly decreased due to the recent improvement in non-farm employment data. It is precisely because of this that the expectation for a 25 basis point rate cut still exists after inflation exceeded expectations. Second, as we discussed earlier, the height of U.S. inflation may be limited. Subsequently, employment data may have a greater impact on rate cut expectations than inflation.

Under the risk of a second round of inflation, we believe the Federal Reserve should still be cautious in controlling the pace of rate cuts, and "stability" may be a more prudent approach. Reducing policy restrictions too quickly could exacerbate inflation and raise the height of the second round of inflation; pausing rate cuts or reducing policy restrictions too slowly could overly weaken economic activity and affect the job market. Neither advancing nor retreating is an easy task, and "stability" may be a more prudent approach.

Risk Factors: Geopolitical risks, international oil price increases exceeding expectations, and the job market weakening more than expected.