The Inflation Trap: Why December Is Now a Live Wire for the Fed

The markets did not get the Christmas present they were hoping for from the last piece of economic data before the Federal Reserve's last meeting of the year.

The US inflation report for October, which came out on Tuesday, was messy, stubborn, and just hot enough to make a normal policy pause into a possible crisis of credibility for the central bank.

The Numbers That Broke the Consensus

It was only a small drop from September's 0.6% increase, but the Consumer Price Index rose 0.4% month-over-month, which was twice the 0.3% increase that most people thought it would be.

More importantly, core CPI stayed the same at 0.3%, even though it was expected to drop to 0.2% when volatile food and energy costs were taken out. This is the third month in a row that the rate has been this high.

The facts are not as good as the headline.

After being stable for months, food prices went up 0.5%, and grocery costs went up 0.4%. It cost 0.3% more to live, which is more than 30% of the score.

Even though gas prices dropped below $4 a gallon after the Iran war spike, the relief was quickly eaten up by the cost of necessities and services.

The government shutdown last year meant that the Bureau of Labor Statistics couldn't make annual numbers. This meant that policymakers could only use monthly data.

Waller's Ultimatum: Credibility on the Line

The political and institutional context makes this data point explosive.

A line was drawn in the sand by Fed Governor Christopher Waller, one of the twelve voting members, hours before the video came out.

As he made it clear, if core CPI came in at 0.3% or higher, the Fed's reputation would be at risk with a mere 25-basis-point hike in December. A 50-basis-point move should be on the table instead.

The data were good enough for him. Waller's reasoning is easy to understand: since inflation has been above target for more than five years, the Fed can't appear weak. He said that the PCE data for September was "bad" and had "no silver lining."

Market Pricing: From 82% to 100%

Market prices changed right away. Futures already gave a December hike an 82% chance before the CPI report.

CME FedWatch showed that there was a 100% chance of a December move within hours of the report coming out. The chance of a half-point increase went from 0% the day before to 15.3%, and the chance of a normal quarter-point increase stayed at 84.7%.

The stock market shook. Dow futures went down, and Nasdaq futures went down about 1% at the start of the day before getting back up on news of an unrelated tech IPO. As bond traders priced in a more aggressive ending rate, Treasury yields went up.

The Political Reckoning

This is not taking place in a vacuum. The midterm elections last week were bad for President Trump's Republican Party. They lost control of both houses of Congress.

Cost-of-living anger was shown over and over again in surveys to be the main problem. The price of gas has gone down, but the cost of food and drinks has not. Economist Justin Wolfers said that the reason for America's "sense of demotion" is that real wages are going down.

The Federal Reserve is now under two kinds of pressure: it can't ignore the problem of inflation, and it can't look too soft on prices in the eyes of the public.

What Comes Next

The direction, if not the size, of the December 8–9 FOMC meeting has now been pretty much decided.

The fed funds rate would go up by 25 basis points, to 4.00%–4.25%. It would go to 4.25%–4.50% with a 50-basis-point change, which would show that the Fed is no longer treading water.

The base case is still a gain of a quarter point. But Waller's clear phrasing - that 25 basis points alone could hurt the credibility of institutions - makes the half-point choice no longer a fringe idea.

If the Fed chooses the smaller move and inflation stays high until 2027, the market will remember that a governor who had a vote on the matter warned them.

It's a clear sign for India and other emerging markets that the dollar's yield advantage is going to grow, which will put pressure on currencies and import bills.

(Edited by Rahul Karunakar; rahul.karunakar@skaah.media)