Hotter-than-expected inflation report puts prospect of October rate hike back in play

Inflation heated back up in September, putting the prospect of an interest rate hike this month back on the table as Federal Reserve officials consider the extent and timing of future hikes.

The Consumer Price Index rose 3.7% in September , compared with expectations for 3.6%, and an acceleration from 3.4% in August. Month-over-month prices rose 0.6%, versus expectations for 0.5%. Stripping out volatile food and energy prices — the way the Fed likes to scrutinize underlying inflation — CPI rose 0.3% month over month, compared with expectations for 0.2%, holding the same level as August. The year-over-year rate was 2.6%, compared with expectations for 2.5%, and up from 2.4% in August.

A big surge in gas prices accounted for over half of the increase. Gas prices rose 9.1% in September, while the energy index as a whole increased 5.2% following a 2.1% increase in August.

Markets were not yet pricing in the likelihood that the Fed will hike rates later this month on the back of the hotter-than-expected CPI report. According to CME Group, traders see just a 43.7% chance of a quarter-point hike later this month, up from about 20% before the inflation report. However, the yield on the 10-year Treasury ( ^TNX ) was moving higher, cresting above 5.3% on Wednesday morning. Markets are pricing in better than 50% odds that the central bank hikes rates for a second time this year in December.

"The upside surprise to core CPI in September was broad-based rather than due to any obvious temporary factors, therefore bringing an October rate hike back into play and presenting upside risks to our forecast for just two more 25 bp hikes from the Fed," said Stephen Brown, chief North America economist for Capital Economics.

A chorus of Fed officials has been calling for further rate hikes to bring down inflation , which has remained above the Fed's 2% target for over five years, while leaving flexibility on when those hikes might occur.

"If the economic data continue to come in as expected, I anticipate additional hikes to support a timelier return of inflation to our 2% goal," Fed governor Chris Waller said earlier this month. "But there is some flexibility about when those hikes will occur. The hikes do not need to come at consecutive meetings, but they should be in place in an acceptable period of time."

The Boston Fed's Susan Collins said Tuesday that it would "be appropriate to raise rates a bit further before the end of the year to ensure a timely and durable return of inflation" to the Fed's 2 percent target. She too said the timing would depend on the data.