The Federal Reserve is widely expected to increase US interest rates when it meets this week, in a move that would protect its credibility in the face of rising inflation while risking a standoff with mercurial US president Donald Trump.
The Fed’s rate-setting federal open market committee (FOMC) meets on Tuesday and Wednesday to determine rates for the world’s biggest economy. The federal funds rate currently stands at 3.50%-3.75%, although Trump has long been vocal in calling for the central bank to cut.
This led to a public spat with former Federal Reserve chair Jerome Powell, who Trump branded a “numbskull”, “moron” and “real dummy” for not speeding up the pace of rate cuts. Current Fed chair Kevin Warsh – who, like Powell, was nominated to the post by Trump – runs the risk of irking the president if he takes a different view on monetary policy.
On Friday, the Bureau of Labor Statistics said the US’ overall consumer price index (CPI) inflation rate was 3.4% for the 12 months to August. This was unchanged from the previous month’s reading and high enough to cause many investors to expect a hike from the Fed.
Jon Butcher, senior US economist at Aberdeen, said: “Warsh reiterated the Fed’s commitment to bring inflation back towards its 2% target during his hawkish speech at Jackson Hole two weeks ago.
“A decision … to keep rates on hold, despite the worsening price data, would raise serious questions about the Fed’s credibility and commitment to price stability.”
Energy was the driving force behind the latest US CPI number, accounting for more than one-third of the rise. The oil price jumped when the US attacked Iran at the end of February and has risen again recently as tensions between the two countries has worsened and Iran continues to keep the Strait of Hormuz closed.
Core CPI inflation, which strips out volatile food and energy prices, was up 0.3% in the month, which was 0.1 percentage points higher than expected.
Anthony Willis, senior economist at Columbia Threadneedle, said: “Given how much weight Warsh has put on the inflation data, and his frustrations with inflation persistently above target for over five years, [Friday’s] CPI print felt like the final piece in the jigsaw for a potential policy move.
“In the aftermath of the August CPI release, a Fed hike now appears to be a done deal.”
The Franklin Templeton Institute said the fed funds futures market indicates an 88% chance of a 25-basis-point hike at the central bank’s 15-16 September meeting and a 63% chance of a hike in December. Before the inflation print, the odds of a September increase were about 70%
Christian Galipeau, head market strategist at the institute, said: “The futures market has the 2026 terminal fed funds rate at 4.09% – the market believes a hike is coming.”
He also pointed out that US two-year treasury notes yield 4.52%, which is about 20 basis points higher than last week and approximately 75 basis points over the federal funds rate.
“Remember, the bond market leads the Fed, not the other way around,” he added.
Meanwhile, US breakeven rates – which show what investors expect inflation to average over a given period – have moved higher, especially the one- and two-year ranges: one-year breakeven rates are 2.55%, up 28 basis points from last week, and the two-year breakeven is 2.44%, up 14 basis points. Five-year breakeven rates are 2.45%, 8 basis points higher than last week.
“Breakeven rates and the two-year note are now seemingly giving the same message: something needs to be done to address inflation,” Galipeau said. “The bond market is telling the Fed to raise rates.”
Last week, the European Central Bank increased rates by 25 basis points. It argued that the conflict in the Middle East looks set to exert inflationary pressures and the hike was necessary to ensure that inflation hits the ECB’s 2% target in the medium term.
The Bank of Japan is expected to lift its base rate in the coming days in response to the same pressures. The Bank of England is tipped to hold the base rate this week, although some forecasters are expecting a hike in the near future.
James Klempster, deputy head of multi-asset at Liontrust, said: “Despite the president's clear desire to keep interest rates relatively low, it appears less and less likely that they're going to be able to keep rates flat when most other central banks are putting rates up.”
David Rees, head of global economics at Schroders, said Friday’s inflation print backed up the asset manager’s view that “the Fed is behind the curve”.
"Until the Fed starts raising interest rates, markets will continue to question its credibility - and the Treasury’s willingness or ability to cap yields,” he said. “The Fed can either choose a rate hike and a controlled rise in short-term US borrowing costs or do nothing and risk an uncontrolled rise in long-term US borrowing costs.”
Seema Shah, chief global strategist at Principal Asset Management, agreed that the US inflation data, when combined with a sharp jump in energy prices and the conflict with Iran, “all but locks in a Fed rate hike”.
The debate now is how many times the central bank will lift rates in this cycle. Principal Asset Management does not expect this week's hike to be a one-off. After five years of above-target inflation, the Fed needs to do more than fine-tune the economy and has limited time to re-establish price stability.
“With the mid-term elections approaching, October may prove politically challenging for additional tightening, making December the most likely opportunity for the Fed to deliver a follow-up hike,” she said.
“Risk assets can comfortably absorb two or three hikes, provided growth and earnings remain strong. But if inflation proves more persistent and the Fed is forced into a more extended tightening cycle, the outlook becomes significantly more challenging.”