Fed Expectations Reverse After Inflation Surprise

The Federal Reserve enters its September meeting facing a dramatically different interest-rate outlook from just one week ago. A Reuters survey of economists now shows 86 of 101 respondents, or approximately 85%, expecting the central bank to raise its benchmark interest rate by 25 basis points to a range of 3.75% to 4.00%.

Such a move would represent the first Fed rate increase since July 2023. The reversal is particularly notable because more than two-thirds of economists surveyed last week had expected policymakers to leave rates unchanged. Fed funds futures are now assigning roughly a 90% probability to a rate increase.

Inflation Has Changed the Policy Equation

The catalyst for the sharp shift was August’s inflation report. Consumer prices increased 0.4% on a seasonally adjusted monthly basis, pushing annual inflation to 3.4%. Core CPI, which excludes food and energy, rose 0.3% during the month, exceeding analyst expectations by 0.1 percentage point.

Stronger producer-price data have added to the concern. Economists now increasingly expect the Fed’s preferred core personal consumption expenditures measure to have accelerated in August. Core PCE is already running at nearly twice the central bank’s 2% inflation target, leaving policymakers with limited room to dismiss persistent price pressures.

The latest data therefore challenge the assumption that inflation would continue moderating without additional policy intervention.

Fed Credibility Is Becoming Part of the Decision

The anticipated rate increase is also about maintaining the credibility of the Federal Reserve’s recent communication. Bank of America senior U.S. economist Stephen Juneau noted that Chair Kevin Warsh had effectively established conditions under which the Fed would need to act unless the incoming data became significantly softer.

That softer data failed to materialize. Instead, inflation proved firmer than expected, increasing pressure on policymakers to align their actions with their previous warnings.

BMO Capital Markets chief U.S. economist Scott Anderson similarly warned that the Fed’s credibility could be at stake. Failure to follow through on hawkish rhetoric, he argued, could produce an even steeper Treasury yield curve as investors demand greater compensation for inflation and policy uncertainty.

Wall Street Has Rapidly Repriced the Outlook

The change in expectations has extended across major financial institutions. Goldman Sachs, JPMorgan, HSBC and Deutsche Bank have all shifted toward forecasting a rate increase this week. Goldman had previously considered a September hike highly unlikely as recently as last month.

Fed funds futures also moved sharply after Friday’s CPI release, with the probability of a September increase rising to around 90% from approximately 72% the previous day. Treasury yields have remained near multi-year highs, reflecting the broader repricing of monetary-policy risk.

Oil Adds Another Inflationary Risk

Energy markets are complicating the Fed’s task further. Crude oil prices remain above $100 a barrel amid continuing conflict in the Middle East, increasing expectations that higher energy costs could feed into broader inflation.

Unlike purely domestic inflation pressures, an oil shock can simultaneously raise prices and weaken consumer purchasing power. That creates a difficult environment for monetary policymakers, particularly if elevated energy costs persist long enough to influence inflation expectations.

Could More Rate Hikes Follow?

The most important question for investors may not be whether the Fed hikes this week, but whether September marks the beginning of a broader tightening phase. A near-majority of economists surveyed now expect at least one additional increase by the end of March.

KPMG chief economist Diane Swonk described the anticipated quarter-point move as potentially an opening step rather than the final increase. That scenario would represent a significant change from the market environment investors had been preparing for only weeks ago.

For financial markets, the trajectory of inflation will determine whether this week’s expected hike remains a limited recalibration or develops into a sustained tightening cycle. If core inflation remains elevated and oil prices stay above $100, the Fed could face increasing pressure to deliver additional increases. Conversely, evidence that inflation begins to cool could allow policymakers to stop after a limited adjustment. Until that direction becomes clearer, Treasury yields, the U.S. dollar and rate-sensitive equities are likely to remain highly sensitive to every new inflation and labor-market signal.