The odds are for a Fed rate hike this week

The good news is that Consumer Price Index (CPI) inflation measures did not get worse, but they also did not improve enough to reduce the chances of the Federal Open Market Committee (FOMC) raising rates at its Sep. 15-16 meeting. As of this writing, the chances of an increase now sit at over 90%. After Chair Warsh's recent comments on needing to see substantial evidence of an improving inflation trend, this expectation is not surprising.

The ongoing, in fact intensifying, nature of the conflict in Iran along with the Russia/Ukraine war have led to not only higher oil prices, but even bigger increases across distillates like gasoline, kerosene (jet fuel), and especially diesel. The average price of a gallon of gasoline in the U.S. is now above $4 and diesel fuel is over $5 a gallon. Despite the Fed removing food and energy from its "core" inflation calculations, market participants know that extended periods of higher energy prices eventually bleed into core measures as energy is such a key part of the production and distribution network. Expectations of an end to the conflict with Iran this summer are fading fast as military strikes increase and are broadening to include new areas of attack. Recent comments by the administration indicate fighting through the midterm elections is possible. Beyond the political implications of higher energy prices and inflation, U.S. consumers continue to feel the pinch of the aggregate inflation in place since the onset of the pandemic.

Additionally, President Trump's recent statement about sending a $5,000 "dividend" check if Republicans maintain control of the House of Representatives and the Senate will not help if the idea is to lower inflation. Estimates are that this action would cost over $1 trillion. Meanwhile, fiscal spending is already at levels that are resulting in unsustainable annual budget deficits and a national debt level exceeding $40 trillion ($34 trillion held by the public). We are now spending almost 20% of government revenues on interest expense and, given today's issuance schedule and interest rates, that share is likely to rise. Historically, we have seen some move towards a level of fiscal restraint when spending on interest exceeded 14%; however, that seems unlikely today.

All of this is not to sound overly negative. Part of the reason inflation remains stubbornly high is U.S. growth is strong, driven by massive capital investment in artificial intelligence (AI) and other industries. Yet, in a nod to the uneven nature of who is benefiting, consumer sentiment levels fell in the most recent University of Michigan survey. We do not expect a rate increase, or even two increases, to materially change the course of the capex boom we are in, but higher rates will impact consumer budgets that are already stretched thin.

Altogether, the Federal Reserve is in a tough spot. Political pressure to lower rates might be leading to a stronger bias to raise rates to assert FOMC independence and credibility. And while there is a case to be made to keep rates steady, we would anticipate an increase at the next meeting. How that occurs, unanimously or with dissents, might influence our views of what comes next.

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