U.S. inflation remained steady at 3.4% in August, matching July's reading and aligning with market expectations, according to the latest consumer price index data released last Friday. Before the release, markets had already priced in roughly a 70% probability of a rate hike at this week's Federal Reserve policy meeting. In the aftermath, short-term U.S. interest rate futures dropped sharply as traders aggressively increased bets on a September move, with odds quickly surging to approximately 90%.
In his Jackson Hole speech, Fed Chair Warsh outlined a data-driven approach to rate decisions, placing inflation trends at the core of the framework. Despite the U.S. economy showing resilience—with strong corporate profits, solid capital expenditure, and a healthy labor market—core inflation measures (PCE and CPI) remain persistently above the Fed's 2% target. While market volatility may be unavoidable, the economy's robustness and non-restrictive real interest rates should cushion any shocks and could potentially bolster the Fed's credibility.
The Fed's decision-making framework: five key themes
Warsh's framework, as presented in his Jackson Hole remarks, can be distilled into five major themes: inflation trends, corporate profits, capital expenditure, market data, and labor market conditions. Corporate profits and capital spending have remained robust. More importantly, a better-than-expected jobs report over the past month has alleviated concerns about the labor market. Together, these factors point to a U.S. economy that remains resilient even in the face of energy price shocks stemming from the Iran conflict.
Warsh explicitly noted in his Jackson Hole address that corporate capital expenditure grew at roughly 9% in the fourth quarter, the fastest pace since 2021, with over half of that tied to artificial intelligence infrastructure. S&P 500 company profits have risen more than 20% over the past year, with margins sitting at historical highs. On the labor front, the unemployment rate holds steady at 4.1%, while the four-week average of initial jobless claims hovers near multi-decade lows, consistent with full employment conditions. Recent employment data have further confirmed this assessment, with earlier fears of labor market weakness largely dissipating.
Consumer spending in real terms remains solid, with domestic private final demand growing close to 3%, showcasing the economy's resilience amid energy price pressures. Credit spreads in financial markets are at historic lows, and bank lending standards for businesses remain relatively loose, suggesting financial conditions are far from notably restrictive. Against this backdrop, market pricing for a U.S. recession in 2026 remains very low at roughly 7%, even as expectations for Fed rate hikes have risen. Warsh emphasized that current economic fundamentals support price stability as the primary policy objective. As such, the main decision point for the Fed's September 17 meeting centers on inflation trends—whether there has been "clear and sufficiently rapid" progress toward the 2% target will be the key determinant for further policy tightening.
Inflation trends: core indicators show no improvement
While the PCE price index is the Fed's official gauge for its 2% inflation target, last week's CPI reading offers crucial clues about PCE's trajectory. Headline CPI matched expectations, and the three-month annualized trend looks encouraging, though it is heavily influenced by volatile energy prices. The Fed is likely to place greater weight on core CPI, which unfortunately came in higher than anticipated, with the three-month average showing an upward trajectory.
Headline PCE rose 3.7% year-over-year in July and has never reached or dipped below 2% since February 2021; the three-month annualized rate has improved to 2.4%. However, core PCE, a better gauge of underlying inflation trends, rose 3.3% year-over-year in July and has also never hit or fallen below 2% since February 2021, with the three-month annualized rate holding at 3.1%. The Cleveland Fed's current estimate for August PCE shows a year-over-year reading of 3.78%, with the three-month annualized rate expected to fall to 1.8%. But the August core PCE estimate stands at 3.4% year-over-year, with the three-month annualized rate likely dropping to 2.7%. That three-month figure is flattered by June's low inflation reading; once June drops out of the calculation, the average could easily climb back above 3%. Taken together, PCE inflation trends show no improvement and are likely to remain above 3% in the near term, making a September 19 rate hike a reasonable expectation.
Market expectations: high probability of a hike, with another possible in December
Federal funds futures have priced in an exceptionally high probability of a 25-basis-point (0.25%) rate hike at the September 17 meeting. Markets also anticipate one additional hike at the December meeting. Setting aside the unusual period following the early-2000s dot-com bust and the protracted stretch after the global financial crisis, real (inflation-adjusted) short-term rates are not particularly elevated, suggesting monetary policy is not excessively restrictive.
The two-year Treasury yield has moved higher, reflecting growing market expectations for an imminent short-term rate increase. The Fed only controls short-term rates, leaving bond yields to market determination. That said, the two-year yield is more directly influenced by Fed actions. Even with that more direct impact, real yields are not at any extreme levels. Notably, the ten-year real Treasury yield has also risen but similarly remains far from extreme territory.
Summary
August CPI data showed headline inflation holding steady while core month-over-month inflation accelerated, directly pushing the probability of a September Fed hike to nearly 90%. Warsh's data-driven framework places inflation trends at the center, with economic resilience providing room for policy action—but core inflation persistently above target remains the key constraint. With markets heavily pricing in a hike, attention will now shift to the policy statement and communication details and their impact on medium-to-long-term expectations.
Frequently asked questions
Q: What were the specific core figures in the U.S. August CPI, and why did markets react so strongly?
A: Headline CPI held steady at 3.4% year-over-year with a 0.4% month-over-month gain, matching expectations; core CPI declined to 2.4% year-over-year but rose 0.3% month-over-month, exceeding the 0.2% forecast. The faster core monthly pace signals a rebound in short-term inflation pressures, particularly from energy and some service prices, which directly pushed the probability of a rate hike from about 70% to nearly 90%.
Q: What is the focus of the decision-making framework Warsh outlined at Jackson Hole?
A: The framework centers on five key themes, with inflation trends at its core. He emphasized corporate profit growth exceeding 20%, capital expenditure growth of roughly 9% (half of which relates to AI), and an unemployment rate of 4.1% consistent with full employment. The economy is resilient, but inflation must show "clear and sufficiently rapid" progress toward 2%; otherwise, further action remains necessary.
Q: Why is core PCE considered more important than headline CPI?
A: PCE is the Fed's official target metric, and core PCE excludes volatile food and energy components, offering a clearer view of underlying trends. July core PCE rose 3.3% year-over-year, persistently above 2%. Combined with the stronger-than-expected core CPI monthly reading, this indicates inflation stickiness remains, supporting the case for another hike.
Q: What impact could a rate hike have on financial markets?
A: Short-term volatility is possible, but economic resilience and non-extreme real rates should cushion the impact. If markets view the Fed's credibility as enhanced, long-term yields could actually decline. The two-year yield has already priced in rate-hike expectations, while the ten-year real yield has not reached extreme levels.
Q: What are market expectations for the path of future rate hikes?
A: The probability of a 25-basis-point hike in September is extremely high, with another potential move in December. The recession probability stands at just 7%, indicating markets believe the economy can withstand moderate tightening, with policy focus remaining on lowering inflation rather than stimulating growth.