Underlying Inflation Hits Lowest Since 2021: Why Markets Bet On Fed Hikes?

Consumer prices excluding food and energy rose 2.4% over the 12 months through August, the slowest pace since March 2021.

Within minutes of that release, traders moved to price in a 90% chance that the Federal Reserve will have raised interest rates next week.

That apparent contradiction has a single explanation, and it is sitting in the gas tank.

The Annual Rate Is Falling, The Monthly Rate Is Not

The 2.4% annual core figure is a backward-looking average that is still shedding the hot prints of late 2025.

What the Federal Open Market Committee reacts to is the monthly run rate and that went the wrong way, rising 0.3% in August after 0.2% in July, a tenth above consensus.

Headline CPI rose 0.4% on the month and held at 3.4% annually.

Energy goods jumped 4.2%, with gasoline up 3.9% and responsible for more than a third of the entire monthly increase. Over the past year, gasoline is up 27.4% and fuel oil 52.0%.

Fed Chair Kevin Warsh singled out the breadth of inflation in his Jackson Hole speech, and in August it moved against him. The share of CPI components rising at an annualized pace above 3% month-over-month climbed to 46% from 45% in July, according to Pantheon Macroeconomics, leaving the three-month average little changed near 44%.

That compares unfavorably with pre-pandemic norms.

Hoping For A ‘Cooling?’ You Will Be ‘Sorely Disappointed’

“Anyone that was hoping for a cooling — or at least moderation — of Core CPI will be sorely disappointed,” said Chris Zaccarelli, chief investment officer at Northlight Asset Management.

“With a 0.3% month-over-month increase in Core CPI, the Fed now finds itself with its back against the wall.”

Samuel Tombs, chief U.S. economist at Pantheon Macroeconomics, abandoned his call for no change next week. “A September rate hike is now very likely, but a tightening cycle looks unwarranted,” he wrote.

Tombs estimates the CPI and PPI data imply a 0.28% rise in the core PCE deflator, annualizing to 3.4% against July’s 3.3%. Seen through that narrow lens, he said, disinflation has stalled. Some FOMC members will weigh the softer prior two months, he acknowledged, though residual seasonality limits that reassurance.

The outlook is what caps the tightening.

Tombs expects near-$100 WTI to add roughly 0.4 percentage points to headline CPI in September, while slowing consumption and near-1% unit labor cost growth should push services firms to moderate price increases.

Pantheon sees September’s move as one-time, with a December hike around a one-in-three chance.

The Case Against Hiking

Not everyone is convinced. Economist Daniel Lacalle said on X that markets are confusing a supply shock with demand, calling the implied 90% probability of a hike unwarranted when August CPI was lifted by energy.

“Rate hikes do not drill a single well, build a pipeline, or lower gasoline prices,” he wrote.

“What they do is raise mortgage, credit card, and business-financing costs, hurting families, investment, and small firms.”

Lacalle pointed to a labor market recovering rather than overheating, with 162,000 jobs added in August, unemployment steady at 4.1% and participation rising.

Hiking into that, he said, “would be a massive policy mistake.”

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