Inflation expected to slow in September but 'upside risks' loom as Fed easing begins

September's Consumer Price Index (CPI) will serve as the latest test of whether inflation will continue to ease as the Federal Reserve debates its next interest rate decision.

The report, due out at 8:30 a.m. ET on Thursday, is expected to show headline inflation at 2.3%, a drop from August's 2.5% annual price increase, which marked the lowest annual rate since early 2021. In the previous month, consumer prices are expected to have risen 0.1%, down from the 0.2% increase seen in August.

On a “core” basis, which strips out the more volatile costs of food and gas, prices in September are expected to have risen 3.2% from a year earlier, unchanged from August's increase. According to Bloomberg data, economists expect monthly core price growth to slow slightly, with estimates for a 0.2% rise compared to a 0.3% rise in August.

Inflation, though moderate, remains above the Federal Reserve's 2% target on an annual basis.

But the Federal Reserve has recently shifted its focus to labor market conditions, which have been surprisingly resilient in the face of higher interest rates.

Data from the Bureau of Labor Statistics released Friday showed the labor market added 254,000 payrolls in September, more than the 150,000 additions expected by economists, while the unemployment rate fell to 4.1% from 4.2%.

The strong report changed expectations about the path forward for interest rates, with markets now pricing in a smaller 25 basis point cut instead of another jumbo 50 basis point cut in November.

Read more: What Fed Rate Cuts Mean for Bank Accounts, CDs, Loans and Credit Cards

“We think the bar is high for the Fed not to cut rates at all in November,” Citi economist Veronica Clark wrote in a note to clients on Monday. “Ultimately, we expect officials to cut rates to 50bp in December, after a 25bp cut in November, amid a still subdued inflationary environment and weak labor market trends over the next few months.”

A hot reading can still make the market scary, though.

“Good news is good news for stocks until inflation picks up again,” Bank of America equity strategist Ohsung Kwon wrote on Monday. “Following last Friday's blowout jobs report, we believe CPI has increased in importance this week.”

“While stocks should be able to withstand a small upside surprise in inflation due to improving macro data, a large surprise could bring uncertainty to the easing cycle and further volatility in markets,” he warned.

Sticky shelter, core service

Core inflation has risen stubbornly due to higher costs for shelter and core services such as insurance and medical care.

“We see some risk of stronger inflation in large components such as owners' equivalent rents compared to our forecast,” the city clerk said. Owner equivalent rent is the hypothetical rent that a homeowner would pay for the same property.

Bank of America added sticky rent inflation and an increase in home-away-from-home, used car prices and airfares will likely translate to a firmer core reading in September after prices in the latter two categories fell in August.

“While we expect core CPI to be on the firmer side from recent readings in September, our forecast does not change our medium-term outlook for further deflation,” Bank of America economists Stephen Juneau and JC Park wrote in a preview of the data. “A cooling labor market and expectations of anchored inflation should keep disinflation on track.”

“That said, there are some downside risks to consider, including East Coast port strikes, rising oil prices and higher shipping costs,” the duo added. “We think these risks will contribute to a more gradual deflationary process than we currently expect.”

Alexandra Canal A senior reporter at Yahoo Finance. Follow him in X @Ali_Khal, LinkedIn, And email her at alexandra.canal@yahoofinance.com.

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