October's U.S. Consumer Price Index (CPI) data came in higher than market consensus, another disappointing inflation report for the Federal Reserve, which is increasingly emphasizing its focus on price stability. Combined with earlier comments from Fed Governor Christopher Waller, the report reinforced the case for another rate hike at the Fed's December meeting and increased the likelihood of a 50 basis point (bp) increase. Our baseline scenario does not currently assume a 50 basis point rate hike in December. However, we are adjusting our forecasts to include 25 basis point hikes each in December and January, with some risk of another hike in March. If Fed Vice Chairman John Williams and Fed Governor Philip Jefferson reinforce Waller's signals in upcoming speeches, this could be enough for us to revise our December forecast to a 50 basis point hike. Even so, we would characterize the Fed's current tightening as a policy "recalibration" aimed at preventing financial conditions from loosening in some way, thus allowing inflation to spread from what should be a temporary shock; it is not the start of a new rate hike cycle. Notable Trends in Inflation Data After a disturbingly high September reading, October inflation was again stronger than the Fed had hoped for. Core CPI, excluding volatile food and energy categories, rose 0.33% month-over-month, with the strong performance relatively broadly across categories. Part of this strength still reflects the transmission of higher input costs from energy, chips, tariffs, and shipping to consumers. Rising global crude oil prices and stronger refining margins have significantly increased the cost of refined products, including gasoline, diesel, and jet fuel. We estimate that these higher costs are also being indirectly passed on through price increases across retail goods and transportation-related services. Combined, this channel could contribute approximately 50–60 basis points to the year-on-year growth rate of core inflation this year. Shipping disruptions related to Iran may amplify these pressures. According to corporate earnings commentary, rising freight and diesel costs, as well as shipping delays, have led some retailers to have below-normal inventory levels ahead of the holiday shopping season. The good news is that a large part of this adjustment should be over. Assuming energy prices broadly follow the current futures curve, we estimate that approximately 70%–80% of the expected transmission effect has already occurred. However, the October CPI report is not just an energy story. Categories that should have been less directly affected by these cost pressures, including housing, leisure, and other non-transportation services, also performed strongly. These categories are typically more closely linked to domestic labor market conditions, wages, and underlying inflation, making their strength in October more noteworthy. So far, labor market fundamentals remain relatively mild. Wage cost pressures have not accelerated again in the manner seen in 2021 or 2022. Rising energy, freight, tariffs, and chip costs can temporarily boost price levels and year-over-year inflation. A more worrying consequence is that these initial price increases are being transmitted to wages, service inflation, inflation expectations, and broader price behavior. We currently do not see compelling evidence that this is happening. Future inflation reports may remain unsettling. Even as some of the initial supply pressures begin to subside, future CPI reports are likely to remain firm as past cost increases continue to be passed on to retail prices. Holiday discounts are one area we are closely watching. Retailers typically offer significant discounts during the holiday shopping season to boost sales. However, this year, shipping disruptions related to Iran have further increased freight costs on top of already rising diesel prices, while also limiting inventory in some categories. Therefore, retailers' willingness or ability to offer discounts may be lower than in previous years. Given the seasonality of holiday discounts, even if underlying input costs no longer rise, smaller discounts than in previous years could mechanically push up seasonally adjusted commodity inflation—although the opposite effect typically occurs after holiday lows in January and February. This creates the possibility that inflation data will remain firm in the coming months, even as oil prices and some of the initial cost pressures have subsided. Implications for Fed policy: Focus on financial conditions. The October inflation report reinforced the case for further Fed tightening, but we still believe this is a policy "recalibration," not the start of another long rate hike cycle. Based on CPI data, we estimate that core PCE rose approximately 0.36% month-over-month and approximately 3.3% year-over-year in October. This level is unsettling, but still well below the inflation rate reached in 2022. The starting point for policy is also drastically different. The current federal funds rate range of 3.75%–4.0% is about 100 basis points lower than our estimated Taylor rule rate, while this gap was about 800 basis points at the beginning of 2022. After several months of strengthening inflation, the Fed is likely to want to narrow this gap, especially given the risk of making a potentially temporary inflationary shock more persistent. Figure 1: The gap between the Fed policy rate and the Taylor rule recommendation, smaller in 2026 than in 2022. Source: Federal Reserve Monetary Policy Report (July 2026). How much additional tightening the San Francisco Fed needs will depend on financial conditions. Higher interest rates across the yield curve, coupled with recent weakness in credit and stock markets, are already doing some of the work for the Fed. The San Francisco Fed's proxy funds rate incorporates broader financial conditions, indicating that the effective stance of policy is closer to the Taylor rule's recommended value than would be suggested by the federal funds rate alone. Therefore, the Fed needs to maintain restrictive financial conditions, but not necessarily a significant increase in policy rates to achieve this. If the stock market rises, credit spreads narrow, long-term yields fall, and inflation remains robust, the Fed will likely need to raise rates further. If financial conditions tighten further, markets can take on more of the work. This framework aligns our expectations for further rate hikes with our forecast of a significant drop in inflation next year. The Fed can tighten now precisely because it wants to ensure that a temporary inflationary shock remains temporary. As the buffer fades, demand should cool. Despite supply shocks this year, U.S. final domestic demand has unexpectedly remained resilient. Capital spending related to artificial intelligence supported investment, although its high import content limited its contribution to U.S. real GDP growth. Consumption also remained robust, with tax cuts and wealth accumulation helping households buffer the impact of rising energy prices and giving businesses more room to pass on higher costs to consumers. These supports should fade. Stock market performance has stalled, the retrospective tax cuts in the Great Beauty Act were more of a one-off boost, and higher interest rates and tighter credit conditions should increasingly weigh on economic activity. In fact, this year's supply shock landed in an economy with demand resilience sufficient to absorb it, but this context should become less favorable in the coming quarters. Conclusion Our baseline scenario remains: U.S. inflation will decline significantly in 2027 as the energy shock subsides, financial conditions remain restrictive, and demand cools. The recent drop in oil prices reinforces this view. The challenge for the Federal Reserve is to prevent the current primarily supply-driven inflation shock from spreading to wages, service prices, and inflation expectations before these inflation-restraining forces take effect. For now, this supports further tightening by the Fed. However, we still view this as a policy "recalibration," not the start of another long cycle of rate hikes. If inflation remains firm and financial conditions ease, the Fed will likely need to do more. If the stock market and credit weaken further, and long-term borrowing costs remain high, the market can tolerate further tightening.