Is "higher for longer" already priced in?

US consumer prices rose 3.7 per cent year-on-year in August, pushed up by a sharp rally in wholesale energy prices. Equity markets had spent the summer pricing a comfortable 'goldilocks' outcome, with inflation fading painlessly and central banks cutting rates in orderly fashion. That story is now in trouble, and 'higher for longer' is finally working its way into valuations.

What drove August

The monthly figure was the bigger shock. Prices rose 0.6 per cent in August alone, the largest monthly increase in more than a year, and petrol accounted for over half of it. The source is supply policy abroad: Saudi Arabia and Russia this month extended their production and export cuts to the end of the year, and Brent crude has climbed above $90 a barrel, its highest since last November. The annual rate had bottomed at 3 per cent in June.

Underneath, a slow grind

Strip out food and energy and the picture is steadier but not reassuring. Core prices rose 0.3 per cent in August, a touch faster than in July, and the annual core rate remains more than double the Fed's two per cent target. Shelter, the largest single element of the core index, is still rising, though more slowly than last year. Market rents on new leases have cooled sharply, and because the official measure tracks rents on all leases, most of which reset only once a year, that cooling should feed through gradually over the coming year.

The stubborn part lies elsewhere. Prices of services other than housing, from car insurance to medical care, depend heavily on wages, and pay growth has slowed only gradually. That is the component the Fed watches most closely, because it reflects domestic demand rather than supply shocks from abroad. A petrol spike on top of sticky services inflation is the combination most likely to keep officials from declaring victory.

Petrol prices spread

Core inflation eased to 4.3 per cent. Dearer fuel, though, acts as a tax on household incomes and could seep into transport costs and then into other service prices. With inflation expectations still fragile, the Federal Reserve cannot afford to look through an energy shock. The futures curve will have to allow for a long plateau of tight policy.

The pass-through runs through several channels. Airlines, delivery firms and hauliers add fuel surcharges within weeks, and those costs reach the price of goods on shelves and of services such as travel. Households spending more at the pump cut back elsewhere, which slows the economy, but they also revise up what they expect inflation to be, and those expectations feed into wage demands. The carworkers' strike against Detroit's manufacturers, which began last week, adds a second supply shock to a car market that has only lately recovered from shortages.

Lessons from past oil shocks

History cuts both ways. In the 1970s the Fed under Arthur Burns treated successive oil shocks as temporary and eased too early, and inflation expectations came loose until Paul Volcker's harsh tightening at the end of the decade. In 2011 the European Central Bank made the opposite error, raising rates twice in response to an oil-driven jump in headline inflation and reversing both moves within months as the euro-zone crisis deepened. The present Fed, having been late to see inflation in 2021, is far more likely to repeat the ECB's hawkishness than Burns's indulgence.

The ECB's record offers another warning. In July 2008, with crude near record highs, it raised rates to fight headline inflation just as the global economy was tipping into its worst downturn in decades. Oil prices collapsed within months, and the increase had to be reversed. Energy-driven inflation is the kind central banks find hardest to judge, because the shock that lifts prices also weakens demand, and the two effects arrive on different timetables.

Bonds adjust first

The repricing is clearest in bonds. The yield on ten-year Treasuries is near its highest since 2007, and investors have pushed back their expectations for the first rate cut. The Fed is expected to leave rates unchanged at the meeting that ends tomorrow, and attention will fall on its new projections, which in June implied one more increase this year. Equities have been slower to adjust, because a handful of large technology companies carried the market higher through the summer on enthusiasm for artificial intelligence.

The winners and losers are easy to spot. Oil producers and refiners gain from dearer crude and wider fuel margins, while airlines and chemical makers, which buy energy as an input, see costs rise faster than they can pass them on. Lower-income households, which spend a larger share of their budgets on petrol, lose most. Long-duration assets such as unprofitable technology shares and long-dated bonds suffer most if the market has to price a longer stretch of tight policy.

The case against is that energy shocks correct themselves. Dear oil squeezes spending, which cools demand, and core inflation, the better guide to underlying pressure, is still falling. If crude retreats, headline inflation would follow quickly and the Fed could declare victory sooner than markets now fear. That requires Riyadh to relent, and nothing in the kingdom's recent conduct suggests it will. The September inflation report, due next month, and the path of crude prices will decide which reading wins.

The calendar is crowded. The Fed's decision tomorrow comes before the August figures for personal consumption expenditure prices at the end of the month, and a federal government shutdown, possible if Congress fails to fund agencies by 30 September, would delay official data just when the Fed most needs it. Oil has pushed headline inflation back up, and 'higher for longer' now looks like a policy the Fed will be forced to follow well into next year, whatever it would prefer. The first casualties are likely to be the richly valued technology shares that led this year's rally, as the discount rate applied to their future profits stays high.