Rising energy prices deal end-of-summer surprise to Fed's inflation outlook

FILE PHOTO: A customer counts his cash at the register while purchasing an item at a Best Buy store in Flushing

By Howard Schneider

WASHINGTON (Reuters) -Federal Reserve officials hoping for evidence of a clear decline in inflation and an economic slowdown have seen a bit of both in data since their meeting in July, all confounded by a fuel price jump that may have made the economy look hotter than it is.

Retail sales and producer prices data released on Thursday provided the last major touchpoints the U.S. central bank will receive before its Sept. 19-20 meeting, and both reports showed spending and prices increasing more than expected - including the fastest jump in producer costs since the peak of the Fed's inflation worries in June of 2022.

The result of a summer jump in fuel prices, the Fed will likely downplay both as a reason to worry about a resurgence in inflation even as it keeps open the possibility of further rate increases later this year.

Retail sales excluding gasoline actually rose just 0.2% in August, a sign consumers "took a needed breather," said Kathy Bostjancic, chief economist at Nationwide Mutual.

With an unusually long eight-week gap between the July 25-26 and Sept. 19-20 meetings, Fed policymakers have a larger set of information to work with in making their next policy decision.

Much of the information has pointed towards a slowing-but-still-growing economy with easing price pressures - the "soft landing" that Fed policymakers have hoped to engineer, and which is expected to lead them to hold the policy interest rate steady next week in the current 5.25%-5.50% range.

Yet the picture is not unambiguous.

Consumer prices on a month-over-month basis also rose in August at the fastest pace since inflation peaked last year, and while that also was driven by volatile energy costs, a measure of underlying inflation accelerated unexpectedly as well.

While economists believe inflation trends are still moving in the Fed's favor - a closely watched measure of profit margins fell last month - the August data represented the sort of surprise that could keep officials leaning towards at least one additional rate increase in new economic projections issued at the end of next week's meeting.

While noting that month-to-month inflation numbers "will inevitably hop around," Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote that he expected underlying consumer inflation to slow to a "benign" level of below 3% by early next year.

At next week's policy meeting "we expect the Fed to remain on hold but to signal willingness to hike again depending on the data," he said.

Updated quarterly economic projections due to be released alongside the policy statement on Wednesday will show if the majority of policymakers still anticipate one further quarter-percentage-point increase by the end of this year, as in their June outlook. Since their meeting in July, only two Fed policymakers have said they felt rates do not need to rise further, while others noted that their outlooks for slowing inflation were built around a slightly higher policy rate.

Investors are largely betting against any further increases, though Fed Chair Jerome Powell has emphasized the central bank's bias will remain in favor of tighter monetary policy, kept tight for longer, until it is clear inflation is on a sustained path back to the Fed's 2% target.

"Is the incoming data telling us that we need to do more? And if it does tell us that - collectively, if that's our view - then we will do more," Powell said at a post-meeting press conference on July 26. The Fed raised rates by a quarter of a percentage point at that meeting.


Within the labor market, watched as closely by the Fed as price data, the pace of job and wage growth has eased, while measures such as the rate at which workers are quitting jobs, the rate of job openings, and the number of unemployed people for each open job, have edged towards the levels seen before the COVID-19 pandemic disrupted the economy.

The Business Roundtable's latest quarterly survey of chief executives showed the economic outlook dipped slightly, as did expectations for hiring and sales.

"Employment growth is slowing, there are fewer job openings, the work week is shorter, the quits rate is lower, and wage growth is declining," Torsten Slok, chief economist at Apollo Global Management, wrote in a recent analysis. As the impact of higher interest rates is felt more fully on firms and households, a fact becoming apparent for example in rising delinquency and default rates, "the macro data will weaken."

Overall bank credit has been falling on a year-over-year basis since mid-July, evidence of financial firms tightening access either through higher rates or stricter standards.

What hasn't happened - and what Powell says is necessary - is a decline in overall economic growth to the sort of below-trend pace that would add to policymakers' confidence that inflation will continue a sustained decline since the summer of 2022, when it hit a 40-year high.

Fed officials generally feel the economy can grow about 1.8% a year with inflation at the 2% target and assuming "appropriate monetary policy."

But U.S. gross domestic product last quarter grew at a 2.1% annual rate, and economists at Goldman Sachs see that pace accelerating to more than 3% in the current third quarter.

The outlook has diminished prospects for a U.S. recession, but may well keep Fed concerns about high - or higher - inflation alive.

Evolving risks, including a possible U.S. autoworkers strike and a federal government shutdown, may argue for caution in the other direction, and many economists expect a slowdown in GDP by the end of the year.

But "the message of the August CPI data is that without a slowdown of growth and higher unemployment, there is no return to 2% core inflation as trend," wrote Steven Blitz, chief U.S. economist at TS Lombard. "The question for the Fed is whether a 5.50% funds rate is sufficient to slow the economy ... There is, in fact, enough doubt to allow the Fed to skip September but let everyone know that November could very well bring about another hike."

(Reporting by Howard Schneider; Editing by Dan Burns, Andrea Ricci and Paul Simao)