Falling Oil Prices May Provide a Cushion Amid Higher-Than-Expected Inflation

The Federal Reserve may be getting an early holiday gift: some breathing room. 

Inflation is still elevated, with October’s consumer price index (CPI) report published Tuesday showing that prices ticked up 0.4% in October, more than the 0.3% that was expected. Those figures are the last official inflation figures the Federal Open Market Committee members will see before they announce whether they’ll hike, hold or cut their benchmark federal funds rate Dec. 9. A hotter-than-expected report could push some members — like Fed Governor Christopher Waller, who indicated before the report that a higher reading could call for a larger-than-usual half-percentage-point increase — toward a hike. 

But oil prices, a major culprit behind inflation of late, are dropping as the geopolitical risk premium unwinds. Brent crude briefly slid below $90 a barrel this week for the first time since August after President Trump said that the war with Iran could end “fairly soon.”  

Crude Cushion

October’s inflation report rattled markets, with the S&P 500 ending the day down 0.38%. But while investors go about deciphering what the Fed will do next, the central bank needs to decipher many mixed signals as it attempts to fight inflation without slowing the economy. Waller isn’t the only one who thinks the battle requires higher rates: Dallas Federal Reserve President Lorie Logan just called for at least two more quarter-percentage-point interest rate hikes. The CME Group’s FedWatch tool shows that traders agree, with the chances of a quarter-percentage-point hike in December at 90.5%, and a half-point hike at 9.5%. 

But eliminate higher energy prices and lingering tariff effects, and the picture changes. Then, “underlying inflation is much closer to the Fed’s 2% target,” Vanguard Senior Economist Josh Hirt said in a recent note:

• Tariffs should provide the most immediate source of inflation relief as the price increases from early last year begin to roll off, he said. By April that mechanical effect alone could bring core inflation, which eliminates volatile items like food and energy, toward 2.5%. The energy effects could take longer to fade, but if there’s no renewed and sustained increase in oil prices, Hirt said their contribution should remain limited.
• The results of the midterm elections are also likely to play a role. Democrats are taking over both the House of Representatives and the Senate in January and ending Trump’s tariffs policy and calling off the war with Iran are among their top priorities. 

Bond Market’s Hand: The bond market may also be doing some of the Fed’s job for it. Tuesday’s auction of $42 billion in 10-year Treasury notes indicated slightly weaker investor demand. When investors demand higher yields in exchange for buying government bonds, it can raise borrowing costs, no matter what the Fed decides to do. The 10-year Treasury yield jumped above 5% before pulling back.