Is Inflation Hotter Than Expected? What Today's CPI Report Means for Your Portfolio

KEY POINTS

• Inflation rose 3.4% year over year in August, matching expectations and holding at July's level.

• Core CPI climbed 0.3% for the month, hotter than the 0.2% economists expected, although the annual rate eased to 2.4%.

• Gasoline prices jumped 3.9% in August, accounting for more than a third of the monthly increase in headline CPI.

• The report keeps pressure on the Federal Reserve, with markets increasing the odds of another interest-rate hike next week.

Inflation Isn't Accelerating Everywhere, But It's Not Going Away

The latest inflation report delivered a mixed message for investors.

The Consumer Price Index rose 0.4% in August, accelerating from a 0.1% increase in July. On an annual basis, consumer prices were up 3.4%, unchanged from July and in line with economists' expectations.

At first glance, that may not sound particularly alarming.

But investors are paying closer attention to what is happening underneath the headline number.

Core CPI, which excludes volatile food and energy prices, increased 0.3% in August. That was above the 0.2% increase economists had expected and marked the largest monthly increase since April. On a yearly basis, core inflation eased to 2.4% from 2.5%.

That combination creates a difficult situation for the Federal Reserve.

Inflation is moving in the right direction over the longer term, but not quickly enough to comfortably declare victory.

Gas Prices Were a Major Problem

Energy was one of the biggest drivers of August's inflation increase.

Gasoline prices jumped 3.9% during the month, accounting for more than one-third of the overall increase in CPI. Diesel prices rose even more sharply, increasing 9.6%.

That matters because higher energy costs can spread throughout the economy.

Transportation becomes more expensive. Businesses face higher operating costs. Shipping costs can rise. Eventually, some of those expenses can find their way into prices paid by consumers.

For investors, the concern is that an extended period of elevated oil and fuel prices could make it harder for inflation to continue falling.

What Does This Mean for Interest Rates?

This is arguably the most important part of today's report for investors.

The Federal Reserve has been trying to balance two competing risks: keeping inflation under control without unnecessarily weakening the economy.

Today's CPI report gives policymakers another reason to remain cautious.

Following the release, financial markets significantly increased the probability of a rate hike at the Fed's upcoming meeting. Reuters reported that rate-hike odds rose to roughly 91%, up from about 72% the previous day.

Higher interest rates generally make borrowing more expensive and can put pressure on valuations, particularly for companies whose expected profits are far into the future.

That makes technology and other high-growth stocks particularly sensitive to changes in interest-rate expectations.

At the same time, higher rates can benefit savers because yields on cash, Treasury securities and other fixed-income investments can remain elevated.

What It Means for Stocks

For stock investors, today's report is not necessarily a reason to panic.

The headline CPI number came in exactly where economists expected, and annual core inflation actually moved lower.

That's important.

But the 0.3% monthly core increase shows that inflation remains sticky enough to keep the Fed on alert.

If inflation continues to run above the central bank's 2% target, investors may need to adjust to a world where interest rates remain higher for longer than previously expected.

That could create headwinds for richly valued growth stocks while potentially benefiting companies with strong current cash flows, pricing power and more defensive business models.

The good news is that today's report did not show a broad-based inflation surge across every category.

Food prices increased just 0.1% in August, while several categories, including medical care and motor-vehicle insurance, posted declines.

What It Means for Your Cash

Inflation matters even if you never buy a single stock.

When prices rise faster than the return on your cash, your purchasing power declines.

For example, earning 3% on cash while inflation runs at 3.4% means your money is technically growing in dollar terms while losing purchasing power in real terms.

That's why the inflation outlook matters for everything from savings accounts to Treasury securities to retirement portfolios.

The good news is that today's report does not suggest inflation is suddenly spiraling out of control.

The bigger issue is that inflation remains stubbornly above the Fed's target, meaning investors may need to prepare for interest rates to stay elevated.

The Bottom Line for Investors

Today's CPI report is neither a disaster nor a clean victory for the Federal Reserve.

Headline inflation held at 3.4%, exactly matching expectations. Core inflation improved on a yearly basis but came in hotter than expected on a monthly basis.

That leaves investors with an important question:

Can inflation continue falling without the Fed having to keep rates higher for longer?

For now, the answer isn't clear.

Investors should keep a close eye on energy prices, core services inflation and upcoming economic data. If those numbers continue to show persistent price pressures, expectations for higher interest rates could remain elevated.

For portfolios, that means the inflation story is far from over.

And with the Federal Reserve's next decision approaching, interest rates could be the next major catalyst for stocks.