August CPI "hot" just right? Wall Street intensively bets on Fed rate hike next week, Waller can't cry wolf this time

The higher-than-expected US core inflation in August is becoming a crucial factor driving the Federal Reserve’s rate hike next week. Although some Wall Street analysts believe that one-off factors such as a sharp jump in telephone service prices exist within the monthly data and are not enough to prove a broad-based reacceleration in inflation, more economists think it is becoming difficult for the Federal Reserve to ignore the warming signals presented by two consecutive months of inflation data.

According to data released by the US Bureau of Labor Statistics on Friday, August 11 US Eastern Time, the CPI rose by 0.4% month-over-month and 3.4% year-over-year, both in line with market expectations. The core CPI, excluding food and energy, increased by 0.3% month-over-month, higher than the 0.2% expected by the market, and rose by 2.4% year-over-year, meeting expectations. Against the backdrop of a hotter-than-expected PPI released on Thursday and international crude oil breaking the $100/barrel mark, this CPI report further reinforced market expectations that the Federal Reserve will hike rates next week.

The interest rate futures market rapidly raised rate hike pricing in response. After the CPI was released, the probability of the Federal Reserve raising rates by 25 basis points at the September 15-16 meeting surged to about 90%, then fell back slightly, and is now around 85%, significantly higher than the pre-CPI level of about 70%. The market has also started to price in a second rate hike within the year. The probability of at least one rate hike this year increased from 94% a day earlier to 97%.

“New Fed Newsletter” Dissects CPI: Core Inflation Eases Annually, but Short-term Trends Rebound

Nick Timiraos, chief economic correspondent of The Wall Street Journal—known as the “New Fed Newsletter”—further broke down the CPI on social media.

He noted that the unrounded month-over-month increase of the core CPI in August was 0.29%, which equates to a 3.5% annualized growth rate. The three-month annualized growth rate rose from 1.6% to 2%, and the six-month annualized rate climbed from 2.4% to 2.6%. The year-over-year core CPI growth rate in the past 12 months slightly dropped from 2.5% to 2.4%, but the decrease was very limited.

In other words, at the 12-month scale, core inflation continues to cool slowly; but on indicators that reflect more recent trends, like the three-month and six-month measures, the cooling process has stalled or even reversed.

Timiraos also reported that core services prices excluding housing surged 0.51% month-over-month in August—the highest since January—and 3% year-over-year; core goods prices increased by 0.11% month-over-month and 0.7% year-over-year; housing prices rose by 0.26% month-over-month, and 3% year-over-year.

However, Timiraos pointed out one major “noise” in the August data: telephone service prices soared by 5.4% in a single month, the largest increase on record, contributing about 0.10 percentage points to core CPI.

Bluetrust Chief Investment Officer Brian McClard stated that telephone service prices have been generally deflationary for about 30 years, yet showed an abnormal spike in August. Timiraos responded that it wasn’t just August—telephone service also evidently boosted core CPI in June.

Therefore, the upside surprise in August core CPI cannot simply be equated to a comprehensive reacceleration of underlying inflation in the US.

Mainstream Wall Street Shifts: Not Necessarily Runaway Inflation, But Enough to Support a September Rate Hike

Despite the above-mentioned “noise,” Wall Street increasingly leans toward the view that the Federal Reserve can hardly stay on hold next week.

Nationwide Chief Economist Kathy Bostjancic stated that the renewed rise in oil, gasoline, and diesel prices raises concerns that energy prices could feed further into other goods and services, boosting inflation expectations. She thus now expects the Fed to hike next week.

Bank of America Senior Economist Stephen Juneau thinks the August data alone does not make him more worried about inflation prospects. The large increase in telephone service is “typically noise and will reverse,” but that does not prevent a hike next week by the Fed.

Bloomberg Chief US Economist Anna Wong and economist Troy Durie also believe the August CPI may not convince FOMC doves to keep rates unchanged, and when combined with the market’s hawkish reaction, it is likely the Fed will have to raise rates next week.

The Wall Street Journal quoted Morgan Stanley Wealth Management Chief Investment Strategist Ellen Zentner as saying that while this CPI report was not as “hot” as the previous day’s PPI, it nonetheless leaves the Fed with even less room to maneuver and maintain its anti-inflation credibility.

Regan Capital Chief Investment Officer Skyler Weinand was more direct: Although the August CPI was basically in line with expectations, inflation is “still too hot,” the Fed is “tied up,” and a hike next week is “almost a foregone conclusion.”

Sharif: The Fed Has Reached a “Take Action or Be Quiet” Moment

Among economists making public comments, Inflation Insights founder Omair Sharif spoke with particular hawkishness.

Sharif stated that the Federal Reserve has reached a “take action or be quiet” moment—if the Fed signaled action at the Jackson Hole meeting, it must follow through next week with a hike, otherwise it risks crying wolf.

Sharif’s judgment refers to Fed Chair Powell’s remarks at the Jackson Hole central bankers’ symposium in August. Powell noted at the time that if the Fed cannot be confident that underlying inflation is moving “clearly and quickly enough” toward the 2% target, policymakers “have more work to do.”

Sharif specifically noted there is an obvious abnormal factor in the surge in wireless communications services in August’s core CPI—excluding this, core inflation would be much milder. Yet, with market pricing for a hike next week reaching nearly 90%, it is hard for the Fed to explain away the overall data with a single outlier.

Now, with August core CPI rising 0.3% month-over-month alongside oil above $100 and an energy shock from Middle East tensions, Powell’s policy space to remain on hold next week has narrowed significantly.

Oxford Economics Still Leaves a Window: Core PCE Might Only Rise 0.2%, Decision Still “on a Knife Edge”

However, not all economists believe that the CPI is enough to determine policy.

Oxford Economics analysts pointed out that what the Fed really focuses on is the Personal Consumption Expenditures Price Index (PCE), not the CPI itself. Given the relatively mild increases in some core goods, they forecast that core PCE may only rise 0.2% month-over-month in August—a relatively moderate level.

If this prediction holds, the Federal Reserve would still have a reason to pause next week.

However, Oxford Economics also believes the policy decision is now “on a knife edge.”

The issue is, several other institutions expect higher core PCE growth in August. If those forecasts materialize, it could further fuel internal Federal Reserve concerns, especially for officials who previously thought cooling inflation in June and July would spark a benign trend—they may now have to reevaluate.

Reuters noted that at least two Wall Street firms have already changed their previous policy forecasts: from expecting the Fed to stand pat in September to now predicting a hike next week.

TD Securities strategists have abandoned their forecast for a hold and now expect the Fed to start a three-hike cycle in September.

TD strategists, including Oscar Munoz and Gennadiy Goldberg, wrote in a Friday research report: “We expect three total rate hikes this cycle, with two more coming in October and January. The Fed may not provide forward guidance, but the dot plot should be hawkish.” The report stated: “After seeing little progress on inflation in August CPI, we expect the Fed to start the hike cycle in September.”

Hodge: Not a Reacceleration of Inflation, Just a “Bump on the Path to Disinflation”

Natixis economist Christopher Hodge offered a relatively moderate assessment.

He believes August’s CPI does not indicate a reacceleration of core inflation, but more likely a “bump on the path to disinflation.”

But that does not mean he opposes a hike next week. Hodge thinks the Fed may see the need for a “nudge” to the economy via one or two hikes—a process likely starting at next week’s meeting.

This view also happens to explain the market’s current mixed response: Wall Street doesn’t necessarily think US inflation has entered a runaway phase, but more and more believe that with the cooling of inflation stalling and oil prices rising again, the Fed needs to adjust policy with an “insurance” hike.

“One Rate Hike” or “Back Into a Rate Hike Cycle”? Wall Street Divergence Emerges

Thus, after the August CPI release, market focus is shifting from “Will there be a hike in September?” to “What will happen after the September hike?”

22V Research Global Macro Analyst Peter Williams believes this inflation report is “clearly not the one the market feared most,” but it is also not one that could “solve the US inflation problem completely.” He thinks the market reaction suggests inflation is “hot enough” to prompt Fed tightening—and this may actually be seen as a good thing, as the market had started worrying policy was too loose and even inflationary.

Lombard Odier Investment Managers’ Head of Macro Research and Multi-Asset Portfolio Manager Florian Ielpo also feels this is clearly not the most concerning inflation report for the market, but far from one that resolves the issue completely.

Northlight Asset Management Chief Investment Officer Chris Zaccarelli said it cannot be said for certain that the Fed “will definitely” hike next week, but it’s difficult to imagine how the Fed could justify maintaining rates in the face of such data.

Plante Moran Chief Investment Officer Jim Baird believes August core inflation is higher than ideal, making next week’s policy meeting more critical. Should the Fed hold steady again, questions about “what exactly is the Fed waiting for” will become even sharper.

eToro US Investment and Options Analyst Bret Kenwell, meanwhile, is focusing on what happens after the hike. He argues that if the Fed characterizes the move as an “insurance hike” in response to reheating inflation—not the start of a new tightening cycle—the market may see it as a “dovish hike.”

In that scenario, short-term Treasury yields may remain high, but upward pressure on long-term yields may actually be tempered.

Markets Lean Heavily Toward a September Hike, But December Hike Becomes New Focus

After the CPI release, rate futures quickly reflected the policy shift.

The market once raised the probability of a September hike to about 90%, then fell back to around 85%—still well above the pre-CPI level of about 70%. Meanwhile, the likelihood of a second hike later this year has also increased.

This means the debate about a September hike is quickly fading, and the bigger question is: Is this simply an “insurance hike,” or the beginning of a new rate hike cycle?

Judging from Timiraos’s breakdown of three- and six-month annualized core inflation, the recent inflation trend is indeed less smooth than previously thought; from Oxford Economics’ view, the PCE figure may be milder than the CPI; while economists like Hodge see August data as perhaps just a short-lived setback on the road to disinflation.

Therefore, the real focus of the Fed meeting next week may not be the 25 basis points themselves, but how Powell explains the move and whether he signals the need for further rate hikes in the future.

If the Fed defines its September move as an “insurance rate hike” against inflation risks, the market may interpret it as a “dovish hike.” However, if Powell signals ongoing tightening, the repricing pressure on US Treasury yields and risky assets may only just be starting.