Saudi Arabia is now in charge of the Federal Reserve

Whether the Fed hikes again now largely depends on oil and energy prices, outside Powell's span of control.

In August, the US headline inflation rose to 3.7%. This was slightly higher than expected, marking a significant increase compared to July, when the inflation rate stood at 3.2%. Moreover, August is the first month since June 2022 when inflation has risen for two consecutive months. The core inflation for August was 4.3%, aligning with expectations, representing a decline from July (4.7%.)

Bad data?

At first glance, the August inflation figures appear disappointing. However, the underlying data is less concerning than the headline inflation rate suggests. Below, we present our US inflation monitor, which displays the annual and, one-month and three-month annualized inflation rates. Like Jay Powell and the Federal Reserve, we primarily focus on the three-month annualized inflation figures. On average, the August inflation rate of our monitor’s six main CPI indicators equaled 2.9%, compared to 2.2% in July.

The rise in energy prices played a crucial role in the monthly 0.6% increase in the headline CPI. The energy component surged by 5.6% in August, marking the biggest monthly increase since June 2022. As a result, the three-month annualized headline inflation rate went from 1.9% in July to 4.0% in August.

Services inflation pretty muted

The table also shows that Powell’s favored inflation metric, the ‘Core Services ex Shelter CPI,’ accelerated to 3.4%. Several seasonal factors contributed to this. For instance, airfare prices rose by 4.9% in August. In addition, rent (outside shelter) prices also significantly increased.

When excluding both ‘Shelter’ and ‘Rents,’ the ‘Core Services excluding Housing’ stood at 2.3% on a three-month annualized basis. This is considerably lower than the ‘Core Services ex Shelter’ and demonstrates that housing continues to dominate the underlying inflation trends.

Another key metric we look at is the ‘Core Sticky excluding Shelter CPI,’ which represents the price development of goods and services that typically change slowly. This increased by 1.8% in August on a three-month annualized basis, higher than the previous month but still below the Federal Reserve’s expectations. Overall core inflation rose 2.4% (3-month annualized,) which is not far from the Fed’s target.

While the US inflation figures for August exceeded expectations, most of this is explained by energy prices and seasonal services. We still expect a further decline in underlying inflation in the coming months, especially if the economy slows.

What now, Powell?

What do the latest CPI numbers mean for the Federal Reserve? Interestingly, the decision to hike or not depends a great deal on Saudi Arabia.

The kingdom recently decided to extend its oil production reduction of 1 million barrels per day until at least the end of this year. As a result, the fourth quarter will witness an oil shortage of around 3 million barrels per day. Consequently, Brent oil prices have risen by 30% since mid-June, with a 7% increase in September alone. The latest spike has yet to be reflected in (September) inflation figures. If Chairman Powell truly wishes to refrain from further interest rate hikes, he must strengthen his argument by focusing on underlying inflation. However, the chances are diminishing that positive inflation surprises allow the Federal Reserve to stop hiking. Saudi Arabia is in the driver’s seat now.

Market dynamics are changing, for the worse

Despite the rate-hike impact of oil prices and Saudi Arabia, the market has adjusted the probability of an additional interest rate hike by the Federal Reserve downwards following the release of the August inflation data. Yesterday, the stock market couldn’t retain its previously achieved gains. A similar pattern was observed last month with a more friendly inflation report. This suggests that inflation’s stimulative effect on the stock market is diminishing. In addition, catalysts that could further push up markets have become scarce. The market has nearly fully priced a ‘soft landing,’ investors are getting more upbeat, and valuation levels remain disturbingly high. Consequently, a potential Fed interest rate hike, driven by oil prices and Saudi Arabia, could act as a catalyst for a downward trend in markets.

Lastly, historically, stocks perform well following a peak in inflation, as evidenced in the table below. However, with a return of almost 18% since last year’s peak in June, historical performance has been entirely priced in. In addition, it’s been over a year since inflation peaked, and typically, other factors beyond inflation, including the impact of Fed rate hikes, begin to exert a more pronounced influence on the market.