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August Inflation Leap Puts 100 Basis Point Fed Rate Hike In Play

Traders are pricing in a 34% chance or a 1 percent rate hike from the Fed next week, the biggest in nearly forty years, following yesterday's hot August inflation print.

Interest rate traders have rekindled bets on a 100 basis points rate hike from the Federal Reserve next week following a hotter-than-expected August inflation reading that shook global markets. 

The CME Group's FedWatch tool, a real-time tracker of market expectations for potential changes in the Fed's target interest rate, suggests at least a 34% chance of a 1 percentage point move when the central bank wraps-up its two-day policy meeting on September 21.

The bulk of the betting-- around 67% -- still suggests the Fed will deliver a 75 basis point hike, its third in succession, that would lift the Fed Funds rate to a range of between 3% and 3.25%.

However, the emergence of at least the potential for a bigger hike, the largest since 1984, suggests many fear an overreaction from the Fed based on Tuesday's surprisingly fast reading for both core and headline inflation. 

Nomura, in fact, is now forecasting the unprecedented 100 basis point move as its base case for next week, noting that “a more aggressive path of interest rate hikes will be needed to combat increasingly entrenched inflation.”

Nomura also lifted bets on a Fed Funds rate of around 4.5% by the end of February, well ahead of the 4% to 4.25% forecast currently priced into the market. 

"Many inflation trends are still falling and peak inflation may still be seen in short months ahead, but the market's confidence in forecasting when it will arrive has taken a major hit," said Louis Navellier of Navellier Calculated Investing.

"Complicating things is that rent is the single biggest component of CPI, at 33%, and is phased in and will continue to rise on past increases even as current levels fall," he added.

The big jump in core consumer prices, which rose 0.6% in August and 6.3% on the year, was powered not only by rising rents, but also by accelerating pressures across a broad range of the products and services, suggesting inflation may be slowly imbedding itself into the world's biggest economy, making the Fed's task of slowing it even more difficult. 

Market reaction to the data, which also showed a headline annual rate of 8.3% that topped Street forecasts, lifted benchmark 2-year Treasury note yields to a fresh fifteen year high of 3.776% in overnight trading, while 10-year notes held at 3.431%, putting the yield curve deeper into inversion as traders calculated the impact of lingering inflation on the economy's growth prospects. 

Ian Shepherdson of Pantheon Macroeconomics, however, notes that the ongoing strength in the U.S. dollar, which makes imported goods increasingly cheaper, as well as expected declines in airfares and used vehicle costs will likely trigger lower inflation readings over the coming months.

:We see no reason to panic on the back of one report; the unfortunate fact is that forecasting these numbers month-to-month right now is much harder than in the pre-Covid era," he said. "But the fundamentals are intact, and we still think markets will be pleasantly surprised by how quickly inflation falls by the middle of next year."