Cornered, Not Convinced: Why the Fed May Hike Anyway

• Headline CPI held at 3.4% in August, unchanged from July.

• The effective fed funds rate sits at 3.63%, so the real rate cushion barely moved.

• The Fed still has room to hold this week, even with Wall Street pricing in a hike.

August’s inflation print didn’t change the math. It just raised the stakes for what the Federal Reserve does with rates this week…

Last week, I laid out why the real rate of interest — the gap between inflation and the Fed’s benchmark rate — still gave policymakers room to sit tight. That argument gets its live test this week, when the Federal Open Market Committee ("FOMC") announces its monetary policy decision on Wednesday.

Since then, the data has only raised the temperature. The U.S. Bureau of Labor Statistics reported Friday that headline CPI held at 3.4% annually in August. That was unchanged from July, even as the non-seasonally adjusted monthly pace increased to 0.3% from no change in July. Core prices, which strip out food and energy, actually cooled to 2.4% from 2.5%.

That’s the tension investors now must sit with. Futures traders are pricing an 85% probability that the Fed hikes rates a quarter point Wednesday. That’s up from 71% the day before the CPI report and about 58% a week earlier. If it happens, it would be the Fed’s first rate increase since July 2023.

Here’s why that’s not as settled as the odds suggest: even with August’s bounce, the annualized pace of inflation is still below the effective federal funds rate. That means the real rate of interest remains positive, implying policy is restrictive, not accommodative. In simple terms, the Fed doesn’t need to hike to keep leaning against inflation. It would likely do so because investors are asking for the adjustment. That means the current setup should support a steady rally in the S&P 500 Index, hike or no hike.

But don’t take my word for it, let’s look at what the data’s telling us…

As I noted at the outset, monthly CPI picked up in August. The month has typically posted only a modest increase since 2000, meaning this latest result ran a bit high. But zoom out and the pattern is narrower than it looks. Outside of March through May, when the run-up in oil prices was at its peak, monthly inflation growth hasn’t been runaway. June undershot its usual pace, and July came in flat.

The driver, again, was energy. According to the Energy Information Administration, the average price of a gallon of gasoline ticked up in August, a milder repeat of the spring’s much larger spike. The Bureau of Labor Statistics’ own gasoline index confirmed the trend, up 3.9% for the month.

The Fed has shown it’s willing to look through this kind of energy noise before. Policymakers held rates in July even as three colleagues dissented in favor of a hike, arguing tariff and energy pressures were broad enough to act on. That patience is exactly what’s being tested this week.

We can see this by looking at the real rate of interest. It’s a measure by which our central can monitor whether the federal funds rate is weighing on inflation growth. A positive number means policy is restrictive while a negative number means policy may be too easy. We can calculate the number by subtracting annualized inflation growth from the effective federal funds rate:

• In May, when inflation was at 4.2% and the effective fed funds rate stood at 3.6%, the real rate was -0.6%.

• That meant our central bank had no rate cut room before it hit neutral.

• With August’s inflation holding at 3.4% and the effective rate at 3.63%, the real rate cushion is back up to about 0.2%, right where it stood in July.

If we look at the historical data going back to 2000, we can see the Fed likely has more room before it needs to act. The real rate of interest has averaged -0.6% during that span. Thought of another way, inflation could climb by another three-quarters of a percentage point or so before policymakers would even be back to their long-run norm, let alone somewhere that truly forces their hand.

Now let’s look ahead. Excluding the spring’s tariff-and-oil-driven spike, inflation growth has been running at a much cooler pace over the past year. So, I extended that trend over the next 12 months and subtracted it from Wall Street’s rate path: a hike this week, with roughly even odds of a second quarter-point move by December, before the Fed goes back on hold through the middle of next year…

The result: the cushion doesn’t vanish, it just narrows. Real rates could dip back toward zero by the end of the year before rebuilding sharply to roughly 2.6% by next May as the year-ago energy spike rolls off.

As I continue to note, the market isn’t irrational, it’s early. Here’s the distinction that actually matters this week: not whether the Fed hikes, but why.

My read: if policymakers move on Wednesday, it’s largely because the market forced their hand, not because the underlying inflation story has deteriorated materially. Fed Chair Kevin Warsh delivered a hawkish message during his Jackson Hole speech. Futures traders followed by pricing in most of a hike. And now, a Fed that’s spent the year defending its independence from White House pressure to cut, has little appetite to look like it’s caving to markets instead of data.

That distinction is what should matter to investors. A rate hike or two to reassert credibility, followed by a pause, is something that investors, and the real rate cushion above, can digest just fine. Until the data says otherwise, the setup still favors the former, and that should underpin a steady, long-term rally in the S&P 500.

Five Stories Moving the Market:

A planned meeting between Iran and several Gulf nations on creating a temporary shipping lane through the Strait of Hormuz has been postponed, according to Omani Foreign Minister Badr Albusaidi; he said the meeting was put off to ensure “appropriate conditions for a constructive dialogue” – Bloomberg. (Why you should care – fighting by Iranian backed militia groups against neighboring Gulf nations appears to be complicating the potential for any meeting)

New strikes on Saudi Arabia and on ships in the Gulf tested nerves in the Middle East, after an attack on a Saudi oil pipeline and an advance by Yemen's Houthis threatened to worsen the wartime ​disruption to global energy supplies – Reuters. (Why you should care – disruption to Saudi Arabia’s east-west pipeline would inhibit the flow of 5 million barrels of oil to global markets)

President Trump and White House AI adviser David Sacks this weekend defended the administration’s strategy of minimal artificial intelligence regulation after the heads of the nation’s top companies endorsed a coordinated slowdown in the technology’s development; Trump said he’s worried about ceding America’s edge over China in a global competition and that winning would help would address the risks from the advancing technology – WSJ. (Why you should care – AI will become an increasing area of focus heading into midterm elections as foreign competitors will seek to hinder U.S. efforts by supporting opposition candidates)

President Trump expressed optimism about resolving a trade fight with Canada and downplayed the prospect of quitting a continental trade pact, in a potential sign of de-escalating tensions between the two countries – Bloomberg. (Why you should care – Canadian Prime Minister Mark Carney signaled last week that he had recently spoken with Trump)

Treasury Secretary Scott Bessent said the U.S. can grow its way out of debt if annual economic growth reaches 3% annually each year; Bessent said that containing spending alongside 3% growth could allow the U.S. to "grow our way out of this" – Yahoo Finance. (Why you should care – Bessent said he’s working on a fiscal consolidation plan with OMB Director Russ Vought to bring down the deficit)

Economic Calendar:

ECB's Schnabel (Executive Board) Speaks (5:15 a.m.)

Canada - CPI for August (8:30 a.m.)

ECB President Lagarde Speaks (11:15 a.m.)

Treasury Auctions $92 Billion in 13-Week Bills (11:30 a.m.)

Treasury Auctions $79 Billion in 26-Week Bills (11:30 a.m.)