US inflation pressures extend beyond energy! AI boom and service costs raise the risk of Fed rate hikes.

This week, international oil prices fell to their lowest level in more than two months, yet US Treasury yields climbed sharply. The market widely expects the Fed to raise rates by 25 basis points in December, with even a 50-basis-point hike possible. Why, when oil prices have fallen, is the Fed's tightening pressure still unabated? The newly released US October CPI report provides the answer: the sources of US inflation pressure have extended beyond the energy sector. Policymakers had hoped that some of the key factors driving prices higherincluding the oil supply shock and service costswould ease. But that has not been the case: excluding the volatile food and energy categories, core CPI rose 0.3% month-on-month, above expectations for a third consecutive month. Chicago Fed President Austan Goolsbee called the October data "almost unsettling." Fed Governor Christopher Waller warned before the CPI release that officials may need to raise rates by 50 basis points at the December meeting. The report also showed that the surge in fuel prices triggered by the Middle East conflict is transmitting to other parts of household budgets. Near-record diesel prices are pushing up transportation costs, services inflation remains firm; at the same time, prices of some goods most affected by tariffs continue to rise. Energy shock spreads to food and transportation The surge in petroleum product prices after the Iran war has effects far beyond the gas pump for US consumers. Food prices are one example: last month grocery price increases hit their highest level since April. Agricultural equipment relies on diesel, and research shows transportation alone accounts for about 9% of retail food costs. Local transportation costsfares for local buses, taxis and ride-hailingposted their largest monthly increase since 2020, with airfares and delivery service costs rising in tandem. Elevated transportation costs could further push up prices of consumer goods. Michael Pearce, chief US economist at Oxford Economics, said the CPI report "really highlights the pass-through effects of higher energy prices." "We knew it would be bad because of the lag effects." Households may be able to postpone purchases of discretionary items such as furniture and electronics, but they have little flexibility when it comes to groceries, utilities and transportation. Services inflation remains elevated The strength in services inflation has also spread beyond categories directly affected by energy costs, such as airfares and express delivery. Services prices excluding energy and rent rose 0.4% in October, after similarly strong gains in the previous two months. Costs for recreational services, motor vehicle insurance and a range of medical services all rose. Owners' equivalent rent, the largest single component of CPI, rose another 0.3%. Services prices tend to be tied to wages, rents, insurance and other operating costs, so they may cool more slowly than goods prices. Without sustained easing, overall inflation may remain elevated. AI and electronics become new variables The artificial intelligence (AI) investment boom is also affecting inflation through technology product prices and overall demand. Over the past three months, prices consumers pay for computers and peripheral equipment rose at a 25% annualized rate. Smartphone prices last month posted their largest increase on record, though this coincided with Apple Inc.'s (AAPL.US) launch of the new iPhone Duo. Electricity prices rose 0.9% in October, the largest increase in six months, with data centers amplifying power demand. Analysts at TD Securities and Morgan Stanley said these increases are consistent with AI-related demand for chips and other electronics. As policymakers try to ensure strong demand does not stoke inflation, the boom in building data centers and related infrastructure is also boosting the broader economy. Preston Caldwell, chief US economist at Morningstar, said in a note to clients that recent data raise "the possibility that the economy heats up again, DRIVE by the massive demand-side boost from the AI boom." "If this trend persists into 2027, it could prompt the Fed to raise rates multiple times." However, Morgan Stanley estimates that AI has contributed only about 6 basis points to core CPI so far this year, but because software and electronics carry greater weight in the core PCE price index, its impact on that index is more pronounced. The risk is that, as the investment boom continues, what has so far been a modest and concentrated source of pressure could become more significant. In sum, this stubborn CPI report further solidifies market expectations for Fed rate hikes. According to CME FedWatch tool data, the market-implied probability of a 25-basis-point Fed rate hike in December has exceeded 90%, with a 9.5% probability of a 50-basis-point hike. However, the market's real concern is not just whether the Fed will hike in December, but that the endpoint of this tightening cycle may be pushed higher and further out.