Hotter inflation makes rate hike more likely now, but it’s not a slam dunk

Trend watch

From gasoline and diesel prices to airfares, seemingly all eyes are currently on crude oil prices and their ripple effects across the economy. That’s been exacerbated by sharp swings in oil prices in recent months. We updated several slides (slide 7 and 8, available to clients in the full report) to provide some context. 

Our take

The energy market remained a major source of economic uncertainty, as U.S. crude oil prices continued their recent rollercoaster ride. While crude prices swung sharply from week to week, consumers felt the impact most directly at the pump. Diesel prices climbed to a new all-time high, while gasoline prices continued their upward march, keeping transportation costs elevated for both businesses and households.

The persistence of higher fuel costs is likely to sustain consumer frustration and reinforce concerns about the affordability of everyday expenses. It appears to have been the case for consumer confidence, which deteriorated in the latest readings as households expressed growing concern about the economic outlook and their purchasing power. Furthermore, short-term inflation expectations surged, reflecting heightened anxiety over rising fuel prices and the possibility that inflation could remain elevated for longer than previously anticipated.

Nonetheless, rising energy costs were a key driver behind another hotter-than-expected inflation report in August. Consumer prices accelerated as higher fuel expenses filtered through the economy, contributing to increases not only in energy-related categories but also across transportation services.

The impact of energy volatility was also evident further up the supply chain. Wholesale inflation remained under pressure in August as fluctuating energy prices continued to boost input costs for producers. These ongoing swings highlight the challenge facing businesses, many of which must absorb or pass along higher costs amid an environment where pricing power is becoming increasingly difficult to maintain. The result is another reminder that inflation pressures are not confined solely to consumers.

Meanwhile, the housing market showed additional signs of weakness. Both sales and prices declined for existing homes in August, underscoring the pressure from affordability challenges and cautious buyer behavior.

Taken together, the latest data paint a picture of an economy still grappling with the effects of energy-driven inflation. Higher fuel costs are seeping further into consumer and producer prices, eroding confidence, and adding strain to key sectors such as housing, leaving both households and policymakers navigating an increasingly uneven economic landscape. There are seemingly just as many reasons to hold rates steady as there are to hike now.

The main argument for holding rates steady is that supply shocks are largely out the Federal Reserve’s (Fed) control. That’s on top of already higher prevailing interest rates. Thus, the combination of higher energy prices and higher rates could slow the economy much more than a casual “tap on the brakes” that a quarter-point rate hike would imply. There’s also inconsistent job growth, especially on a month-to-month basis (162,000 in August, but just 21,000 and 31,000 in July and June, respectively). Moreover, despite the hotter August prints, the three-month averages for consumer and wholesale inflation remain below their prior 12-month averages.

Conversely, the case for a rate hike now is built on curbing inflation, which is increasingly creeping into services. Of course, it’s showing up in categories such as airfares, which increased 2.7% month over month in August and jumped 23.4% from a year ago as jet fuel prices have spiked. But there’s evidence that spillover effects of the ongoing oil shock are starting to appear in other services, such as hotel prices and wireless phone bills.

Ultimately, the August hotter inflation prints make a quarter-point rate hike more likely at next week’s Fed meeting, although it’s not a slam dunk.

Bottom line

Rising energy prices are driving hotter inflation and, in turn, higher interest rates, which weighs broadly on the households and businesses. The Fed faces a difficult tradeoff: hold rates steady because the inflation shock is supply-driven and growth remains uneven, or hike rates to prevent higher energy costs from spreading further into services inflation. As a result, a quarter-point rate hike next week appears more likely, though far from certain.