Hopes of Peak US Inflation Shattered Again; Will the Fed Go for a Bigger Hike?

Hot US Inflation

The Fed's preferred measure of inflation – the core Personal Consumption Expenditures – had moderated in July, to +4.6% year-over-year and created and the lowest level since late-2021, while the headline figure had also been encouraging.

This had created fresh optimism that inflation may have peaked, but these hopes were shattered by yesterday's latest inflation report, in the form of the August Consumer Price Index (CPI).

This report revealed that headline CPI eased further to 8.3% year-over-year, as oil prices have dropped significantly over the last few months, but this was still higher than expected.

Most importantly, excluding energy and food prices, inflation accelerated to the highest level since March, since the Core CPI came in at 6.3% year-over-year in August, from 5.9% prior.

Fed Implications

The release came just a week ahead of the Fed's upcoming policy decision - which is announced on Wednesday September 21 - and was definitely closely watched by its members.

The central bank has implemented an aggressive tightening cycle in order to reign in inflation, having already delivered 225 basis points worth of rate hike, including two consecutive and historic 0.75% moves in the last meetings.

Policy makers have scrapped explicit forward guidance as their actions weigh on the economy and make their job harder and Chair Powell has hinted towards a potentially slower path in the future. However, bank officials made a series of hawkish remarks and touted their resolve to fight inflation recently, just before the communication blackout period kicked in.

In some of the most recent remarks, Chair Powell called for strong action "until the job is done" on Thursday ^[1], while a day later, Governor Waller had talked of a "significant increase" in the policy rate ^[2].

Market had come to expect another 75 basis points hike for next week's meeting, but yesterday's inflation report has created some anticipation for an even more aggressive 100 basis points move.

At the time of writing, CME's Fed Fund futures assign the highest probability to the first outcome (66%), but see 34% chance of a 100 bps hike - from 0% before the CPI figures. Moreover, they now project rates to go as high as 4.5% in 2023, from 4% previously. ^[3]

For reference, the Fed's Staff Economic Projections from June expect the median rate to be 3.4% by the end of 2022 and 3.8% by the end of the next year. Next week they will provide their updated projections, that will be one of the focal points, for more insights into the thinking of policy makers.

Market Reaction

We don't know if the Fed is ready to go beyond an 0.75% increase in the upcoming policy meeting, but Tuesday's inflation figures definitely put pressure for a more aggressive move and markets clearly see a possibility of such an outcome for the time being.

The release and the upgraded expectations around the Fed's tightening path, sparked a US Dollar rally and sent Wall Street and the bond market into a free fall.

SPX500 and NAS100 registered yesterday their worst day since March 2020 and the height of the pandemic, while FXCM's two-year 2USNote also plunged.