Inflation hits 3.2%. The last mile begins

Headline inflation fell to 3.2 per cent in October, and core prices rose at their slowest annual pace in two years. Equity bulls were delighted. Bond investors know that the easy part of disinflation is over. The 'last mile', from three per cent to the Fed's two per cent target, will be the hardest stretch of the whole campaign.

What the report showed

The October figures were softer than expected almost everywhere. Consumer prices were flat on the month, helped by a drop in petrol prices, and core prices, which exclude food and energy, rose by 0.2 per cent. Core inflation over the past year eased to 4.0 per cent. Treasury yields fell sharply on the release, the dollar weakened and stocks rallied, as futures markets moved to price rate cuts by the middle of next year and all but ruled out another increase.

How the first miles were won

The fall from the peak of more than 9 per cent in June 2022 came largely from forces that are now spent. Supply chains untangled after the pandemic, shipping costs collapsed, and the price of used cars, which had soared when chip shortages throttled new-car production, fell back. Energy prices dropped from the spike that followed Russia's invasion of Ukraine. Base effects did the rest, as the big monthly increases of 2022 dropped out of the annual comparison. None of those forces can be repeated.

Services won't budge

Core inflation is stuck near four per cent, held up by shelter costs and by wages in services outside housing. Cheaper oil may make headline figures look benign for a while, but price pressure in domestic services has not gone away. If the Federal Reserve cuts rates early on the strength of the headline numbers, it risks reviving expectations of a wage-price spiral and repeating the stop-start mistakes of the 1970s.

Shelter is the largest single item in the index, at roughly a third of the basket, and it moves slowly because leases reset only once a year. Measures of rents on newly signed leases have slowed sharply, and they tend to lead the official figures by many months, so shelter inflation should ease through next year. The harder problem is everything else in services, from car insurance and repairs to medical care and restaurant meals. Those prices depend mainly on wages, and wage growth, at around 4 per cent a year, remains well above the pace consistent with 2 per cent inflation unless productivity improves markedly.

The Fed's preferred gauge is the personal consumption expenditures price index, which gives shelter a smaller weight than the consumer-price index, and core inflation on that measure has been running below its CPI equivalent. That gap means the Fed's own yardstick may reach target somewhat sooner than the CPI suggests. The October PCE figures, due at the end of the month, will show whether the softening carried through.

The 1970s warning

The historical parallel that haunts central bankers is 1980. The Fed under Paul Volcker had pushed rates to record levels, but when the economy slipped into recession that spring it cut sharply. Inflation stayed high, and the Fed was forced to reverse course and raise rates to even higher levels, producing a deeper recession in 1981 and 1982. Arthur Burns's Fed had made a similar mistake earlier in the decade. The lesson officials draw is that easing before inflation is clearly beaten can cost more in the end than holding on too long.

The Fed has signalled that it has absorbed that lesson. It held its policy rate at 5.25 to 5.50 per cent at its meeting on 1 November, and officials have said repeatedly that they would need several months of good data before concluding that inflation is on a sustainable path to target. The committee's projections in September showed rates staying above 5 per cent through most of next year.

Who gains, who waits

The market's enthusiasm has already rewarded holders of long bonds and growth stocks, whose value rises most when expected rates fall. Borrowers have gained too, as mortgage rates retreat from nearly 8 per cent. If the Fed keeps rates high for longer than markets now expect, those gains are vulnerable, while holders of cash and short-dated bills, who earn more than 5 per cent, keep collecting. Households with floating-rate debt, such as credit cards, will not see relief until the Fed actually cuts.

The optimists' case

The counterargument is not weak. Core inflation measured over the past three or six months has been running well below its annual rate, and if shelter slows as rents on new leases suggest, core inflation could approach 3 per cent by the middle of next year without any rise in unemployment. Productivity growth has been strong this year, which allows wages to rise faster without pushing up prices. On this view the last mile may be shorter than feared.

That scenario is possible, but it requires several things to go right at once. The labour market is still tight, with unemployment at 3.9 per cent, and service-sector wages show only gradual moderation. The data to watch are monthly core services excluding housing, the quarterly employment cost index, and the Fed's projections at its meeting in mid-December.

Inflation fell from nine per cent to three per cent because supply chains healed and base effects helped. Getting it to two per cent will take a slower economy and a weaker jobs market, which markets are not priced for. The Fed is unlikely to cut as soon as investors hope, and the first cut is more likely to come in the second half of next year than the first.