If investors thought that the July report on the U.S. consumer price index (CPI) heralded the start of a significant moderating trend in inflation, the August CPI release disabused that notion. On September 13, the U.S. Bureau of Labor Statistics reported year-over-year headline of 8.3%, versus 8.5% in the prior month. The core CPI index, which excludes food and energy prices, came in at 6.3%, up from 5.9% in July. The August headline CPI exceeded expectations by 0.2% and the core CPI came in 0.3% ahead of forecasts.

What caused the overshoot? Higher-than-expected inflation was pervasive across product categories except for used cars, airline fares, and communications services. The most striking feature of current inflation is the very high rates in necessities: food (up 0.8%, month-over-month), rents (up 0.7%), and medical care (up 0.7%).

While month-over-month spikes are concerning, the real worry for the U.S. Federal Reserve (Fed) is the likelihood that inflation will remain “higher for longer.” One feature that suggests inflation at a rate above the Fed’s 2% target has become firmly embedded is that even as consumer spending rotated from goods to services, core goods inflation has remained persistently high. There are also hints that more rapid increases in labor costs are behind the pickup inflation in services excluding rent and energy.

One other factor worth noting is that even though headline inflation overshot forecasts by 0.2% in August, it was up only 0.1%; even though the market expected a decline of 0.1%, the August monthly increase suggested that headline inflation is not accelerating. That could spell another month of strong real income growth in for U.S. households, and thus, continued strong demand. On the other hand, core inflation, the best indication of current and future price pressures, remains very high. Low headline inflation accompanied by high core inflation is not a desirable situation, because it suggests that demand is being stimulated by wage gains while inflation remains at elevated levels.

Policy & Investment Considerations

That points up the difficulty the Fed faces in engineering current policy. The sustained period of high inflation has likely locked in a 75-basis point (bp) rate hike at the September 20-21 meeting of the Fed’s policy-setting arm, the Federal Open Market Committee (FOMC), and may have also put another 75-bp hike on the table at the November meeting. There is even some speculation that the Fed could raise rates by 100 bps in September, based on trading in fed funds futures, though that does not look likely to us at the present time.

How might investors respond in such an environment? One approach would be to emphasize shorter-duration assets, and to the extent possible, less economically sensitive assets. That approach may serve investors well in an environment where core inflation has remained so far above the pace consistent with the Fed’s target for so long that the FOMC has no choice but to continue raising rates aggressively.