US inflation exceeds expectations again! Probability of a Fed rate hike in September rises above 85%, market starts betting on another hike this year

According to Zhitong Finance APP, U.S. inflation heated up again in August, increasing the pressure on Federal Reserve Chair Walsh to raise rates at next week's monetary policy meeting. Following the release of the latest data, market bets on a Fed rate hike in September surged rapidly, with the probability jumping from about 70% on Thursday to over 85%. Some economists who previously expected the Fed to hold rates steady also began shifting their forecasts to a rate hike.

Data released by the U.S. Bureau of Labor Statistics on Friday showed that the core Consumer Price Index (CPI), which excludes food and energy prices, rose 0.3% month-over-month in August, higher than expected. As U.S. inflation has remained above normal levels for several years, this data further strengthens the view among some Fed officials that there is a need to raise interest rates to curb price pressures.

Omair Sharif, founder and president of Inflation Insights, stated bluntly that for the Fed, it has reached a point where it must prove its anti-inflation resolve through action. Federal funds futures indicate that after the inflation data was released, investors now believe there is more than an 85% chance the Fed will hike rates at the September 15-16 meeting, up significantly from about 70% on Thursday. Moreover, the market currently expects the Fed may raise rates again by December.

Economists’ expectations have also changed rapidly. Before the CPI release, the economic community was far less aggressive in predicting a September rate hike than the financial markets; but after the data, multiple institutions including TD Bank and JPMorgan revised their forecasts, now expecting the Fed to raise rates next week.

Diane Swonk, chief economist at KPMG, said this inflation reading has further shifted the focus of Fed policy discussions towards rate hikes. She believes the question has now gradually moved from "Do we need to raise rates?" to "How much do we need to raise rates to control inflation?"

It is worth noting that the rise in core inflation in August was largely driven by a record increase in wireless communication service prices, which may be a one-time factor. However, several analysts believe that with inflation remaining high, it is difficult for the Fed to continue holding rates unchanged simply based on future expectations of price improvement.

Walsh Faces a “Credibility Test” After Previous Hawkish Statements

Besides the latest inflation data, Walsh’s prior hawkish remarks have also put extra focus on next week’s meeting. In a speech at Jackson Hole on August 28, Walsh said core U.S. inflation had not shown meaningful improvement, and if future data cannot further demonstrate that inflation is moving back toward the Fed’s 2% target, policymakers still have “work to do.”

Sharif believes that after making such comments, it would be difficult for Walsh not to support a rate hike at the next meeting.

Bloomberg Economics’ economists Anna Wong and Andrew Sacher also pointed out that the signals from the market are already clear: investors want and expect the Federal Open Market Committee (FOMC) to raise rates. If the Fed ultimately does not hike, Walsh’s credibility among market participants could be undermined.

In fact, support within the Fed for tightening policy has already started to increase. Although the Fed has kept the benchmark rate unchanged for five consecutive meetings this year, at the July meeting, three officials voted in favor of a 25-basis-point hike, and two non-voting officials also stated that if they had voting power, they would support a hike.

Evercore ISI economists Krishna Guha and others said on Friday that a rate hike by the Fed next week now seems very likely. They believe that with oil prices further adding to inflation pressures, Walsh may feel that the current data is not sufficient for the Fed to disregard inflation risks, and hiking now would also help restore credibility in his previously impacted policy stance.

Soaring Oil Prices and Rising Inflation Expectations Further Reinforce the Case for Rate Hikes

Another major challenge for the Fed comes from the energy market. With ongoing tensions with Iran, international oil prices have soared again, with Brent crude reaching $109 per barrel at one point on Thursday. Meanwhile, structural factors such as data center construction driving up prices are not likely to abate in the short term.

Consumers’ anxiety about inflation has also risen significantly. The latest survey by the University of Michigan shows that U.S. consumers’ inflation expectations for the next year jumped from 4% in August to 4.6% in early September; meanwhile, for the first time since 2023, more than half of consumers expect interest rates to rise over the next 12 months.

The labor market has also not shown obvious deterioration that would force the Fed to be more cautious. Although wages currently do not seem to be a major driver of inflation, the U.S. unemployment rate remains low and is generally seen as stable. Some Fed officials even believe that the current level of interest rates may not be restraining demand as much as previously estimated.

As a result, the market has started to debate whether the Fed needs to reverse the cumulative 75-basis-point rate cuts implemented last year in response to labor market slowdown risks.

Joseph Brusuelas, chief economist at RSM US, even believes the Fed should roll back the three rate cuts planned for the end of 2025 to cool what may be U.S. economic growth well above trend level.

However, if Walsh ultimately chooses to raise rates, it could once again trigger political pressure from the White House. Trump has long demanded lower rates from the Fed and last week even threatened that if the Fed does not cut rates, he may halt trade with countries running trade deficits with the U.S. White House National Economic Council Director Hassett said on Friday that if the Fed takes “big moves,” the President is expected to respond.