The Big Picture

Briefing.com Summary:

*The August Consumer Price Index didn't produce enough progress on inflation. 

*Various market signals are pointing to a rate hike at the September 15-16 FOMC meeting.

*The Fed's inflation-fighting credibility is on the line.

A rate hike in September appears to be in order. That was part of our summation in last week's column. It is the introduction to this week's column, knowing that the market's response to the August Consumer Price Index (CPI) made it so.

Following the CPI report, the fed funds futures market ratcheted up the probability of a 25-basis point hike at the September 15-16 FOMC meeting to 86.3% from 69.4%, according to the CME FedWatch Tool.

The probability of the FOMC leaving the target range for the fed funds rate unchanged at 3.50-3.75% is still greater than 10%, which is the same chance a lead researcher at Anthropic ascribed to AI possibly killing all humans within the next decade.

We can't be sure then that we'll be alive to write about Fed meetings ten years from now, but we are sure the FOMC should be voting to raise the target range for the fed funds rate to 3.75-4.00% less than a week from now.

Inflation Progress Lacking

Simply put, the August CPI report just wasn't convincing enough to forestall a rate hike. Total CPI was up 3.4% year-over-year, unchanged from July, while core CPI was up 2.4%, a smidgen below the 2.5% rate registered for the 12 months ending in July.

That isn't much progress on inflation. Fed Governor Waller (FOMC voter) recently said he could be inclined to vote for a rate hike if progress toward the 2.0% inflation target wasn't seen in the August inflation data. Granted he might split hairs and say the 2.4% year-over-year increase in core CPI is "progress," but the market, for one, isn't seeing it that way.

Following the CPI report, the 2-yr note yield jumped nine basis points to 4.64%, leaving it up 26 basis points for the holiday-shortened week and 28 basis points for the month. Yes, most of the rate-hike recalibration at the front of the curve has come more recently, driven by the spike in oil prices, which topped $100/bbl in the past week.

Energy prices are, of course, excluded from core inflation, so the move by the 2-yr note yield suggests market participants are thinking high oil prices (and gasoline and diesel prices) are going to stick for a bit and raise the risk of second-round effects through transportation, production costs, and inflation expectations.

Notably, the 5-year breakeven inflation rate, which is a measure of what market participants expect inflation to be in the next five years, on average, ticked up to 2.46% from 2.37% at the end of last week.

That isn't a major jump, but directionally, it is an objective problem for Fed Chair Warsh and the FOMC going into the September 15-16 meeting. It is another market-based signal suggesting investors see inflation risks as remaining uncomfortably elevated.

The inflation target, admittedly, is tied to the PCE Price Index, yet the read-through from the August Producer Price Index and Consumer Price Index reports suggests there isn't going to be enough progress seen at the end of September in the August PCE and core-PCE price indexes, which stood at 3.7% and 3.3% in July—well above the 2.0% target.

Briefing.com Analyst Insight

The summation this week is that Fed Chair Warsh can't afford to steer an FOMC decision to stand pat with its policy rate. His speech in Jackson Hole intoned that "The Fed needs clear market signals, as unfiltered as possible," to get policy right.

Well, the market's signals are flashing green light go for a rate hike:

• The fed funds futures market sees a near 90% probability of a 25-basis-point rate hike.
• The 2-year note yield is up 26 basis points in just the last week.
• The 5-year breakeven inflation rate is moving close to 2.50%, away from the 2.0% inflation target.
• The PCE and core-PCE price indexes aren't—and won't be—close to the "fixed, firm" 2.0% target.

Ignoring these signals and not raising the target range for the fed funds rate would undermine the Fed's inflation-fighting credibility.

--Patrick J. O'Hare, Briefing.com