Last Friday (September 11), the U.S. Department of Labor released the August Consumer Price Index (CPI). The data showed that the U.S. inflation rate remained at 3.4%, unchanged from July and in line with market expectations. Prior to the data release, the market had already priced in a roughly 70% probability of a rate hike at the Federal Reserve's policy meeting this week. After the data release, U.S. short-term interest rate futures fell rapidly, with traders significantly increasing their bets on a September rate hike, quickly revising the probability of a rate hike upward to approximately 90%. In his Jackson Hole speech, Federal Reserve Chairman Warsh outlined a data-driven framework for interest rate decisions, with inflation trends at its core. Despite the resilience of the U.S. economy—strong corporate profits, robust capital spending, and a healthy labor market—core inflation indicators (PCE and CPI) remain stubbornly above the Fed's 2% target. While market volatility may be unavoidable, the economy's resilience and unrestricted real interest rates should mitigate the impact and potentially boost the Fed's credibility.

The Federal Reserve's Decision-Making Framework: Five Themes

Warsh's framework in his Jackson Hole speech can be summarized into five main themes: inflation trends, corporate profits, capital expenditures, market data, and labor market conditions. Corporate profits and capital expenditures have remained strong. More importantly, the better-than-expected jobs report in the past month has alleviated concerns about the labor market. These factors collectively point to a resilient U.S. economy despite the energy price shocks from the Iranian conflict. Warsh explicitly pointed out in his Jackson Hole speech that corporate capital expenditures grew by about 9% in the fourth quarter, the highest since 2021, with more than half related to artificial intelligence infrastructure construction; S&P 500 company profits have grown by more than 20% over the past year, with profit margins at historically high levels. Regarding the labor market, the unemployment rate has stabilized at 4.1%, and the four-week moving average of initial jobless claims is near a multi-decade low, generally consistent with full employment. Recent employment data further confirms this assessment, and previous concerns about a weak labor market have largely subsided. Consumer spending remains robust, with domestic private final demand growth approaching 3%, demonstrating the overall economy's resilience in the face of energy price shocks. Credit spreads in financial markets are at historically low levels, and banks' lending standards for businesses are relatively lenient, making it difficult to argue that financial conditions are significantly restrictive. Against this backdrop, the probability of the market betting on a US recession in 2026 remains very low, at only about 7%, despite some increases in expectations of a Federal Reserve rate hike. Warsh emphasizes that current economic fundamentals support price stability as the primary policy priority. Therefore, the main decision point at the Fed's September 17 meeting will be the inflation trend—whether there has been a "clear and sufficiently rapid" improvement towards the 2% target—which will be the key factor in determining whether to further tighten policy.

Inflation Trends: Core Indicators Show No Improvement

While the PCE price index is the official measure of the Federal Reserve's 2% inflation target, last week's CPI readings can provide key clues about its trajectory. Overall CPI met expectations, and the 3-month annualized trend looks encouraging, but it was heavily influenced by volatile energy prices. The Fed likely places more emphasis on core CPI, which unfortunately exceeded expectations, with the 3-month average showing an upward trend. Overall PCE rose 3.7% year-over-year in July, never reaching or falling below 2% since February 2021; the 3-month annualized rate has improved to 2.4%. However, core PCE is a better measure of underlying inflation trends—core PCE rose 3.3% year-over-year in July, never reaching or falling below 2% since February 2021, and the 3-month annualized rate held steady at 3.1% in July. The Cleveland Fed's current estimate for August PCE shows a year-over-year increase of 3.78%, with the 3-month annualized rate expected to fall to 1.8%. However, the estimated year-over-year core PCE for August is 3.4%, with the 3-month annualized rate expected to fall to 2.7%. This 3-month annualized rate was shrunk by the low inflation readings in June. Once the June data is released, the average could easily return to above 3%. Overall, the PCE inflation trend has not improved and is likely to remain above 3% in the short term, making a rate hike on September 19th expected.

Market expectations: The probability of an interest rate hike is extremely high, with another one expected in December.

The federal funds futures market has priced in a very high probability of a 25 basis point (0.25%) rate hike at the September 17 meeting. Another rate hike is expected at the December meeting. Aside from the unusual period following the dot-com bubble in the early 2000s and the prolonged period after the global financial crisis, real (inflation-adjusted) short-term interest rates are not expected to be high, and do not indicate excessively restrictive monetary policy. The 2-year Treasury yield has risen, reflecting increased market expectations for an upcoming short-term rate hike. The Fed only controls short-term interest rates, therefore the market determines Treasury yields. That said, the 2-year yield is more directly affected by the Fed's actions. Even with a more direct impact on the 2-year yield, the real yield is not at any extreme level. It is worth noting that the 10-year real Treasury yield has risen, but it is also not at an extreme level.

Editor's Summary

August CPI data showed overall inflation remained stable while core inflation accelerated month-on-month, directly pushing the Fed's September rate hike expectations to nearly 90%. Warsh's data-driven framework places inflation trends at the core, with economic resilience providing support for policy space; however, persistently high core inflation remains a key constraint. With the market heavily pricing in a rate hike, subsequent focus will shift to the impact of policy statements and communication details on medium- to long-term expectations.

Frequently Asked Questions

Q: What are the key data points for the US August CPI? Why did the market react so strongly? A: The overall CPI remained stable at 3.4% year-on-year and rose 0.4% month-on-month, in line with expectations. The core CPI fell to 2.4% year-on-year, but rose 0.3% month-on-month, higher than the expected 0.2%. The accelerated month-on-month increase in core CPI indicates a rebound in short-term inflationary pressures, especially driven by energy and some service prices, directly leading to a surge in the probability of an interest rate hike from about 70% to nearly 90%. Q: What are the key points of the policy framework proposed by Warsh at Jackson Hole? A: The framework focuses on five themes, with inflation trends at its core. He emphasized that corporate profits grew by over 20%, capital expenditures grew by about 9% (half of which was related to AI), and the unemployment rate was close to full employment at 4.1%, indicating strong economic resilience. However, inflation must fall "clearly and quickly enough" to 2%, otherwise action is still needed. Q: Why is core PCE more important than overall CPI? A: PCE is the official target indicator of the Federal Reserve. Core PCE, which excludes volatile food and energy prices, better reflects underlying trends. July's core PCE rose 3.3% year-on-year, remaining above 2% for an extended period. Combined with the core CPI's better-than-expected month-on-month increase, this indicates that inflationary stickiness remains, supporting the necessity of interest rate hikes. Q: What impact might a rate hike have on financial markets? A: Short-term volatility is possible, but economic resilience and non-extreme real interest rates are expected to mitigate the impact. If the market perceives an improvement in the Fed's credibility, long-term yields may actually decline. The 2-year yield has already priced in rate hike expectations, and the 10-year real yield has not reached extreme levels. Q: What are the market's expectations for the subsequent rate hike path? A: The probability of a 25 basis point rate hike in September is extremely high, with another possible hike in December. The probability of a recession is only about 7%, indicating that the market believes the economy can withstand moderate tightening, and the policy focus remains on suppressing inflation rather than stimulating growth.