Resilient Growth, Sticky Inflation

by Nikhil Mohan of Franklin Templeton, 10/22/26

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Last week saw a further deterioration in the inflation outlook, while the Federal Reserve (Fed) appears increasingly reluctant to tighten again immediately. The September headline Consumer Price Index (CPI) rose 0.6% month/month (m/m) and 3.7% year/year (y/y), while core inflation increased 0.3% m/m and accelerated to 2.6% y/y from 2.4%. Energy accounted for more than half the headline increase, but the underlying picture was not particularly reassuring: Shelter inflation accelerated to 0.4% m/m, while several services and goods categories also recorded increases. The more concerning signal came from the Producer Price Index (PPI), which surged 1.3% m/m and 6.3% y/y, its strongest monthly increase since March 2022. Although energy was the main driver, prices excluding food, energy and trade services rose 0.5%, while import prices increased another 1.1%. The risk is increasingly that elevated energy and input costs feed through into broader consumer inflation, rather than remaining a temporary headline shock.

The growth picture remains resilient, but the divergence between nominal spending and underlying consumer purchasing power is becoming more pronounced. September retail sales increased a stronger-than-expected 0.8% m/m, but excluding gasoline stations, sales rose only 0.2%. Higher prices are therefore accounting for a meaningful portion of the increase in spending. The latest Federal Reserve’s “Beige Book” report reinforced this divergence: Most districts reported little change in consumer spending, with growth increasingly concentrated among higher-income households. Meanwhile, real average hourly earnings are now down 0.7% y/y and stagnant for the past six months. This is worth watching because it suggests household purchasing power is weakening despite relatively healthy aggregate consumption. However, initial jobless claims remained exceptionally low at 199,000, indicating that the labor market continues to suffer more from weak hiring than rising layoffs.

See more: Consumer Price Index: Inflation at 3.7% in September

The industrial sector remains an important source of strength. September industrial production rose 0.7% m/m, exceeding expectations, although manufacturing output increased by a more modest 0.3%. Utilities production jumped 3.5%, consistent with continued strong electricity demand associated with artificial intelligence (AI) infrastructure investment. This reinforces the theme that AI-related investment continues to support economic activity, even as higher energy prices and interest rates weigh on other sectors. The expansion is therefore becoming more dependent on a relatively narrow set of growth drivers.

The Fed is facing a more difficult policy trade-off, but an October pause remains the most likely outcome. The latest inflation reports strengthen the argument for additional tightening, while softer payroll growth, weaker real earnings and uncertainty around the consumer argue against moving too quickly. Fed Chair Kevin Warsh offered little indication of the Fed's intentions during his October 16 remarks, reiterating his reluctance to provide forward guidance ahead of policy decisions. Markets ended the week assigning roughly an 85% probability to rates remaining unchanged on October 28, despite the upside inflation surprises. We retain our view that the Fed will pause later this month, while a December hike remains firmly in play. The more important question is whether the Fed can afford to remain patient if higher input costs continue passing through into consumer prices. The September Beige Book offered little reassurance on that front, with four districts reporting an acceleration in price increases and firms anticipating further increases as existing contracts expire.