Patient, But Not for Long

• The average price for a gallon of gasoline rose about 3% in July.

• Regional Fed prices received data showed a decline last month.

• The scenario could drive real rates higher.

Prices are rising again, and the Fed’s cushion is getting thinner…

This week delivers a key update for investors tracking the Federal Reserve’s monetary policy outlook. The U.S. Bureau of Labor Statistics (“BLS”) will release its September Consumer Price Index (“CPI”). And if my drives to my son’s away soccer games are any guide, gas prices are up.

According to the Energy Information Administration (“EIA”), the average gallon of gasoline last month cost $4.49. Based on my calculations, gas prices rose 7% on a month-over-month basis in September, as tensions in the Middle East kept crude elevated. That marked two straight monthly increases, but not at the pace we experienced in the spring…  

As the chart above shows, the first half typically produces the bulk of the price growth for the year.

• Gas prices typically rise just 0.2% in September.

• The Cleveland Fed’s staff projects headline CPI could rise to 3.6% compared to 3.4% in August.

• That could increase Wall Street’s anxieties about an October rate hike.

Chairman Kevin Warsh has signaled our central bank is willing to be patient. Recent commentary from policymakers, like John Williams, Beth Hammack, and Christopher Waller, indicates their anxieties are up, but they’re willing to be patient at the upcoming meeting of the rate-setting Federal Open Market Committee. Based on the data I track, price growth rose once more. And given that the Fed raised rates last month, it gives policymakers room to stay on hold.

But don’t take my word for it, let’s look at what the data’s telling us…

To get an idea of what inflation growth might look like each month, I built a gauge using monthly manufacturing and services index data from the Dallas, Kansas City, New York, and Philadelphia Fed districts. These surveys ask businesses whether activity is rising, falling, or holding steady, and then publish indexes to capture the change. Together, these regions represent roughly 32% of national economic output. I focus on the “prices received” components because they serve as a proxy for CPI.

Each district is weighted by its contribution to national growth, giving us a cleaner read on how they influence the overall picture.

• In September, the combined manufacturing prices‑received index came in at 28.6.

• That’s up from 23.9 in August but below the May peak of 31.3.

• It snapped two straight monthly declines.  

  

Manufacturing accounts for about 10% of domestic output. Services matter more. That sector includes healthcare, education, finance, hospitality — the parts of the economy where most Americans work and spend.

• My gauge shows the services index rose to 23.7 in September.

• That compares to the 20.5 peak in April and 16.7 in August.

• That’s above the range of recent outcomes and the highest since early 2023.

  

Next, I blended the two measures, weighting them by economic importance and their relevance to CPI. Because services dominate the U.S. economy, they carry more sway in the combined reading.

• The composite came in at 25.6 for September.

• That compares to 19.2 in August and the recent peak of 24.2 in April.

• This is above the recent range.

This matters because it tells the Fed that companies are raising prices on consumers. They’re likely passing on the elevated fuel costs from the last few months. In fact, the details show New York accounted for the majority of the increase, yet the gauges in Dallas, Philly, and Kansas City also experienced gains. The rise was driven by fuel costs, not a broad-based surge, but policymakers’ tolerance is wearing thin. If prices keep surging, another rate hike is all but certain.

So, the last step is to measure the Fed’s interest rate cushion. We can do this by looking at the real rate of interest (effective federal funds rate minus inflation). A positive number means policy is weighing on price growth, while a negative number means rates are stoking inflation. According to the most recent CPI figures, rate hikes aren’t yet necessary…

In August, the effective federal funds rate was roughly 3.6% while inflation stood at 3.4%. That means policy is about 20 basis points above the so‑called neutral level, where rates neither help nor hinder growth. And since the Fed has managed the real rate to an average of –0.6% since 2000, it implies policymakers have 80 basis points of room to maneuver.

Now let’s apply the Cleveland Fed’s 3.6% CPI estimate for September. Because our central bank increased the federal funds target range to 3.75% to 4%, it means the current rate‑cut cushion held steady at 0.2%. When we factor in the long‑term average, it tells us the Fed still has more wiggle room.

Bottom line: measured against neutral, the margin for rate cuts is thin. The Fed still has room to remain patient, but likely not for long if prices keep running hot. Beyond that, lower borrowing costs next year can come from this spring’s inflation spike dropping out of the year-over-year math, with a Middle East resolution speeding that up. That should help to underpin a steady, long‑term rally in the S&P 500.

Five Stories Moving the Market:

The United States' response to Iran's seven conditions in a proposal to reopen the strategic Strait of ​Hormuz was "insufficient", according to Iranian Security Chief Mohsen Rezaei; Iran presented a proposal during the UN General Assembly under which the Strait of Hormuz waterway could be reopened and ​normal maritime passage restored within seven days if the conditions ​were met – Reuters. (Why you should care – it’s looking increasingly likely that the conflict will drag on well past the midterm elections))

President Donald Trump said Sunday that Russia and Ukraine have agreed to an “energy ceasefire” effective immediately; Ukrainian attacks on Russian refineries and other energy assets prompted Moscow to impose a temporary ban exports of most diesel, jet fuel, and gasoline in July, which it recently extended through October – Bloomberg. (Why you should care – the White House is pulling every lever it can to try and lower fuel prices ahead of midterm elections in early November)

Federal Reserve Bank of Cleveland President Beth Hammack is worried that interest rates are currently doing little to restrain inflation growth; she’s hearing from companies and constituents in her district about demand for goods outstripping supply in addition to families choosing which bill to pay because of surging cost – WSJ. (Why you should care – Hammack is possibly the most hawkish policymaker and has repeatedly called for raising the federal funds target range)

The Federal Reserve’s latest Survey of Consumer Finances shows far slower wealth gains than experienced during the volatile pandemic years, when stock markets plummeted and then soared, and households banked trillions of dollars in federal support payments – Reuters. (Why you should care – the survey showed household debt remained stable while leverage declined)

Bond markets are starting to do some of the lifting for central banks around the world by pushing up borrowing costs themselves, potentially reducing the number of benchmark interest-rate hikes needed to get inflation under control – Bloomberg. (Why you should care – Federal Reserve Chair Kevin Warsh has said that rising bond yields mitigates the need for the U.S. central bank to raise interest rates)

Economic Calendar:

Earnings: FDX

U.S. - Columbus Day; Bond Market Closed, Stock Market Open

Markets are closed in Canada and Japan

BoE's Breeden (Deputy Governor) Speaks (5:30 a.m.)

BoE's Mann (MPC Member) Speaks (8:50 a.m.)

Fed's Hammack (Cleveland, Voter) Speaks (12:50 p.m.)

U.K. - BRC Retail Sales Monitor for September (7:01 p.m.)

Japan - PPI for September (7:50 p.m.)

RBA Monetary Policy Meeting Minutes (8:30 p.m.)

IMF - World Economic Outlook Released (10 p.m.)

IMF - Global Financial Stability Report Released (11:15 p.m.)