What Just Happened: What is CPI inflation, and why does it matter?

What just happened?

US Consumer Price Index (CPI) inflation vexed markets in September, with headline CPI inflation falling less than expected on an annualized basis and core CPI inflation ticking upwards over the same period. Investors have been broadly hoping for US inflation figures to continue grinding down toward the Federal Reserve's (Fed) 2% annual inflation target, but September's CPI inflation print vexed markets, kicking the legs out from beneath broad-market risk appetite.

Why does CPI inflation matter?

CPI inflation is a measure of the month-on-month change in consumer-level prices for a mixed basket of consumer goods that represents a significant cross-section of the overall consumption economy. While the CPI index lacks consumer price information for rural residents, measuring only the cost changes in urban goods, the CPI index as a broader measure of consumer inflation captures roughly 93% of the US population.

Since controlling inflation via interest rates is a full half of the Fed's mandate (with the other half being stable employment, a feature unique to the Federal Reserve not shared by other central banks), CPI inflation is used by markets as a key method of estimating when the Fed will make changes to the Fed funds rate, and by how much. With inflation continuing to run above the Fed's target levels, upticks in key inflation metrics makes it harder for the Fed to deliver rate cuts as fast or as furiously as investors would like to see.

What happens next?

With CPI inflation registering hotter than expected in September, investors will be turning to the rest of the economic data docket for signs of weakness that might spur the Fed back into a faster pace of rate cuts heading into the end of the year. Labor market weakness has been earmarked as a likely ignition point for further higher-than-expected rate reductions. However, too far into the red on jobs data or other inflation metrics (like the Personal Consumption Expenditure Price Index) could also spark fear of a widespread recession in the US economy, leaving investors in a challenging 'Goldilocks' position: markets are hoping for soft spots in the US economy to force the Fed to reduce interest rates, but a direct tip-over into recession will render rate cuts a moot point.