A third consecutive inflation surprise shifts December’s question from “Will the Fed hike?” to “By how much?”

Executive summary

The consumer price index (Consumer Price Index (CPI)) measures changes in the prices of a basket of goods and services consumers buy. The US index rose 0.4% in October after seasonal adjustment, which removes the effect of recurring patterns during the year. Core inflation, which excludes food and energy, rose 0.3%. Analysts’ consensus forecasts were 0.3% and 0.2%, respectively. The core reading is not large in itself, but it is the third consecutive reading to exceed expectations by the same margin. It lifted the three-month annualized rate of core inflation to 3.75%; this converts price changes over three months into an annual pace. That is almost twice the 2% target of the Federal Reserve, the US central bank.

The market was not questioning a rate hike on 9 December: one was already likely before the release. The question became the size of the increase and the subsequent rate path. After the data, interest-rate futures priced in a rate hike as certain. The probability of a fifty-basis-point increase (Basis Point), or half a percentage point, rose to between 10% and 15% during the day. Governor Christopher Waller had said that same morning that a core reading of 0.3% or higher would warrant considering such a move.

This report traces the shock from the components of the reading to the Fed’s calculations, then to the yield curve, which shows bond yields by maturity. It follows the effects on the dollar, gold and equities, then on the personal consumption expenditures measure (Personal Consumption Expenditures (PCE)), which tracks prices of what individuals consume and is targeted by the Fed. It then turns to investment fund positioning, other central banks and Gulf currencies pegged to the dollar. Three findings stand out:

First, the bond shock was a shock to real yields (Real Yield), meaning yields adjusted for inflation. It was not a shock to inflation expectations, meaning estimates of its future path. The ten-year real yield rose 12 basis points, while market-implied inflation compensation (Breakeven Inflation) for the same maturity fell from 2.22% to 2.20%. In other words, the market read the figure as signalling higher rates for longer, rather than a loss of confidence in the Fed’s ability to bring inflation down.

Second, the market reaction exceeded the norm. Across 18 previous upside core inflation surprises since 2022, the median rise in the two-year yield was 7 basis points, and the median dollar gain was 0.36%. The median is the middle value when observations are ranked. On 10 November, the yield rose 17 basis points and the dollar gained 0.60%. Part of the difference is explained by asset managers, who manage investments, holding their largest long position in ten-year Treasury futures since records began in 2006. A long position benefits from rising prices. Futures are contracts to buy or sell an asset at a later date.

Third, the path to December runs through three milestones. It starts with the Producer Price Index (Producer Price Index (PPI)) on 13 November, which measures changes in producers' selling prices. Next come the October meeting minutes on 18 November and personal consumption expenditures on 25 November. Preliminary estimates for the latter, which remain subject to revision, range between 0.34% and 0.4% month on month; enough to lift the annual rate from 3.12% to around 3.3%.