Federal Reserve faces no easy choices with stubborn inflation and economic strains

WASHINGTON (TNND) — The Federal Reserve appears poised to make its first rate hike since 2023 after hotter-than-expected inflation and fears that higher oil and diesel prices could become entrenched in the economy with few indications the war in Iran will close anytime soon.

The report shifted the discussion around interest rates from when officials will move them to how many hikes will be necessary to get inflation back to target. The question facing the Fed may be what happens after this week with persistent inflation making it unlikely a single increase will be sufficient as higher borrowing costs put a squeeze on economic activity.

Inflation climbed 3.4% on an annual basis in August after rising 0.4% from July. “Core” inflation, which takes out food and energy categories, rose 0.3% to 2.4% from a year ago, an improvement from the month prior but still above the central bank’s target.

Investors are all but certain the central bank will approve a quarter-point increase to its benchmark interest rate at the end of this week’s meeting. There is also little belief one hike will suffice to rein in inflation that has been stubbornly above its 2% target for more than five years, raising the prospect of more to come. There has only been a single one-and-done rate hike cycle since the 1990s.

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Investors are pricing in a nearly 90% chance of an increase coming out of this week’s meeting, according to the CME FedWatch tool. They are also pricing in another quarter-point hike by the end of the year, which would bring the Fed’s benchmark interest rate up to 4% to 4.25%.

While markets have broadly priced in at least one hike this year, higher rates do not come without risks and many analysts see a meaningful debate over whether to hold this week.

Stubborn inflation, risks from energy prices and AI spending and a desire to keep inflation expectations anchored are driving the argument to raise rates. Meanwhile, core inflation hit a multi-year low last month, the labor market is not adding to price pressures and there are questions about whether interest rates will be effective in pushing inflation down.

Officials have held off on increasing rates, expecting monthly inflation would slow in the back half of the year with tariff effects easing and a slower-but-solid labor market keeping wages from spiking and adding to inflationary pressures.

Pressure to increase rates was already building within the Fed before the latest inflation figures. Three officials dissented at the July meeting in favor of an increase, while others have indicated in speeches that they would support an increase if inflation doesn’t make meaningful progress toward the target.

An energy shock from the war in Iran has added to the Fed’s challenge of bringing inflation down. Oil moved back above $100 a barrel and diesel prices eclipsed $6 a gallon for the first time in U.S. history last week, increasing the chances consumers may soon face higher costs if higher transport costs are passed on to consumers.

Central banks typically try to look through spikes in energy prices under the assumption they will be temporary, but the sustained pressure on energy costs is raising the risks those increases spread deeper into the economy.

Fed chair Kevin Warsh’s address at last month’s economic symposium in Jackson Hole, Wyoming also elevated expectations of a rate hike, even though he did not offer clues on the timing for it or what specifically would get him to support one.

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“Here is my standard: We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed,” Warsh said. “Otherwise, we have work to do.”

Warsh’s remarks in Jackson Hole were some of his clearest insight offered publicly into his views of the economy and inflation. He has intentionally cut back on forward guidance from the Fed, arguing markets had become too reliant on it and should react to real economic conditions.

After the July meeting, Warsh’s lack of explanation on the Fed’s decision to stand pat stirred concerns in markets about how he planned to return inflation to target. Markets reacted by selling off bonds, pushing yields on government debt higher and adding to pressure on borrowing costs.

“With the market positioned for a hike, a Fed decision to hold steady could have an impact on the Central Bank’s credibility and lead to higher inflation expectations. Hiking on the 16th may help preserve that credibility and eliminate the need of having to raise rates more aggressively in the future in order to preserve its perception as a bulwark against inflation,” said Gary Pzegeo, chief investment officer of CIBC Private Wealth U.S.

Raising rates comes with its own risks, especially with much of the recent inflation pressure stemming from an energy shock that interest rates do little to address.

Unemployment is low but the labor market has been in a low-hire, low-fire balance for months outside of August. Consumer spending is also under strain as households struggle to absorb higher gas prices as inflation has outpaced wage gains for five consecutive months. A new round of rate increases would add higher borrowing costs onto those pressures and could squeeze the economy.

“The odds of a serious Fed policy mistake are uncomfortably high and rising,” Mark Zandi, chief economist at Moody’s Analytics, said on social media. “If the Fed tightens to bring inflation down faster, it must push growth below potential, and that is hard to do without layoffs, rising unemployment, and igniting a self-reinforcing negative cycle.”

Policymakers are trying to balance the risk of allowing a prolonged shock to become embedded against weakening other parts of the economy that are not responsible for higher prices and are more sensitive to interest rates.

Increasing interest rates would also put Warsh and the Fed at odds with the White House. Several administration officials, including President Donald Trump, have argued the Fed does not need to hike and sought cuts to help lower borrowing costs for consumers.