U.S. inflation may worsen before it improves, which will raise questions about the speed of Federal Reserve rate cuts.

Since spring, inflation has been increasingly close to the target level of 2%. The Federal Reserve's preferred inflation measure has slowed from a 40-year peak of 7.3% two years ago to 2.1% in September.

However, the pace of price increases has accelerated in recent months—Federal Reserve officials have referred to it as 'bumps'—and inflation is expected to rebound before the end of this year.

It is estimated that the annual rate of the PCE index favored by the Federal Reserve is expected to rise from 2.1% in September to 2.3% in October.

Citigroup economists estimate that by the end of the year, this reading could rise to a high of 2.6%, before starting to decline again in 2025.

If one considers the so-called core inflation excluding food and energy, the data looks even worse. Federal Reserve officials believe that core inflation can better predict future inflation trends.

Since July, the annual rate of the core PCE index has remained stagnant at 2.7%, and it may rise to 3% by the end of the year.

What’s going on? Is inflation worsening? Perhaps not.

Some economic sectors have recently experienced accelerated price increases. The largest increases have been in transportation costs, such as car insurance, car repairs, and airfare.

Rent and home prices have not only failed to slow as expected but have also risen faster than usual. Housing is the largest driver of inflation in the U.S. and is the largest single expenditure for most households.

However, outside of these categories, most consumer prices are either increasing very slowly or even declining completely.

So, why is overall inflation rising? Economists have a dazzling explanation for this as always: the base effect.

The annual inflation rate is calculated based on the average price increase over the past 12 months. Each time a new inflation data is reported, the earliest month is excluded.

In 2023, there was basically no inflation in October and November, with a month-on-month increase of only 0.15% in December.

If the PCE inflation index averages an increase of 0.2% per month in the last three months of 2024, then as last year's low readings are excluded, the annual inflation rate will inevitably increase.

'The base effect means that inflation may rise in November and December,' said Michael Pearce, deputy chief U.S. economist at Oxford Economics.

However, if the rise in the annual inflation rate is considered a statistical illusion, that would also be incorrect.

Economists have noted that short-term price indicators have also risen this fall.

Regions Financial chief economist Richard Moody said inflation 'has proven to be more persistent than many expected and may tick up slightly in the coming months.'

However, despite the recent 'rebound' in inflation, most senior Federal Reserve officials and Wall Street economists believe that inflation will return to a downward trend in 2025.

The question is when.

At the beginning of each new year, many companies raise their prices. Government economists try to account for expected increases when adjusting inflation reports for seasonal changes, but they have struggled to measure this correctly in recent years.

The result is what Federal Reserve Chairman Powell referred to as 'seasonal residuality.' In simple terms, he believes that the government's official price index exaggerates inflation at the beginning of the year.

How much has it been exaggerated? This is left for everyone to guess.

Economists say that all the Federal Reserve can do is review various reports on inflation and economic health, and then make their best guess about when the 2% inflation target can be achieved.

Financial markets have scaled back their predictions for the number of rate cuts by the Federal Reserve in 2025. Unless investors see faster progress in reducing inflation at the beginning of the new year, they may become more pessimistic.

Moody's stated: 'While few expect inflation to continue accelerating in the coming months, without further deceleration, this could easily disrupt the outlook for the degree and speed of (Federal Reserve) rate cuts.'

Article forwarded from: Jin Ten Data