The October CPI report showed the economy is continuing to heal from the inflation heatwave that spread like wildfire in 2021 and 2022, providing further assurance that inflation is moving steadily back to the Fed’s 2% goal. Headline CPI was unchanged month-to-month (consensus +0.1%) while core CPI rose just 0.2% (consensus +0.3%), bringing the year-over-year rates down to 3.2% and 4.0%. The underlying details also show disinflation has more room to run with the few “hotspots” of inflation unlikely to be sustained.

Across the key inflation categories (1) energy, (2) shelter, (3) core goods and (4) core services:

• Energy provided the biggest driver of disinflation in October, with a sharp 5% decline in gas prices reversing some of the 11% and 2% gains in the last two months. Progress should continue with gas prices continuing to slide in November.
• Shelter continues to dominate overall inflation, accounting for almost 70% of the 3.2% annual increase in headline CPI. Owner’s equivalent rent, which accounts for the bulk of this component, peaked this spring and still has a long way to go with a 9-12 month delay to marketplace reality. According to Zillow, rent inflation has fallen from a peak of 16% y/y in March 2022 down to 3% y/y in October.
• Core goods inflation has been squeezed out of the economy with October marking the 5^th consecutive month of deflation. Inflation was soft across a broad range of goods (such as apparel, furniture, school supplies and toys) but most importantly in new car prices (-0.1%) and used car prices (-0.8%).
• Services ex-housing and energy inflation continues to be highly influenced by auto insurance. Elsewhere, hotel rates fell by 2.9% and airline fares declined 0.9%, in-line with favorable forecasts from Hopper on flight costs after a busy summer season.
  • Transportation services this month may have been boosted by an annual update in the auto insurance methodology¹. Regardless, private sector data from BankRate show that the national average car insurance rate is up to $2,014 in 2023 from $1,771 last year, a 13.7% increase². While this surge is surely pinching consumer wallets and likely dragging on overall car sales, its unlikely insurance providers can continue to hike premiums at this rate when demand is cooling and auto inflation has made considerable progress.
  • Elsewhere, medical services will recede as a driver of disinflation. After health insurance averaged 3.8% monthly declines last year, it looks set to rise by close to 2% per month in the next year. This is because of the indirect way BLS measures health insurance, relying on “retained earnings” data for healthcare providers with a lag. October is the first month the CPI began incorporating the 24% annual surge in retained earnings that occurred in 2022³.
  • Going forward, progress on transportation services will be key for disinflation in this “super core” category, with further help from receding wage inflation and the lagged pass-through effects from lower goods inflation.

Overall, this report provides a welcome signal that the inflation war is all but won. Combined with a soft payrolls report, we think the risk of a Fed rate hike at their December meeting is reduced even further, particularly as early indicators point to a similarly mild November CPI report. While this may not hasten Fed rate cuts or reduce hawkish messaging, it should allow long-term interest rates to decline further, providing support to both stocks and bonds and allowing for a resumption of the U.S. dollar’s decline.

For the economy, the ingredients for a soft landing remain on the table, but the weight of monetary tightening is gradually passing through various channels to consumers and businesses, despite mild consequences thus far. For markets, disinflation could pose an earnings headwind for certain industries like autos, hotels and airlines while the Fed’s “higher for longer” mantra could instill continued volatility in bond markets.

¹Once a year in October or November, the BLS rolls each vehicle in their sample of car insurance premiums a year younger to keep the overall sample age constant. This can lead to higher premiums if newer models are associated with higher expenses from cost of repairs or vehicle prices.

²Rates are based on a 40-year-old driver with a 2021 Toyota Camry, 12,000 miles annually, clean driving record and good credit. Source: BankRate, “Why is car insurance so expensive in 2023?”

³This year, the BLS updated its methodology on retained earnings to smooth the effects of the annual updates. The BLS will now use a 2-year moving average of the retained earnings ratio and will use semiannual updates as opposed to annual updates. This should smooth some of the usual volatility in this metric around October/November and may limit the pass-through of the 24% surge in retained earnings to the health insurance index. 

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