Modest CPI reading gives Fed no clear direction on rates

• Key insight: Price growth continued to run above the Federal Reserve's 2% target in August, but remained consistent with recent months. The central bank will have to decide if that trend is moving up or down.
• Expert quote: "To paraphrase John Lennon, I'm willing to give disinflation a chance." — Federal Reserve Gov. Christopher Waller
• Forward Look: The Federal Open Market Committee is set to meet next Tuesday and Wednesday to determine whether to raise interest rates or keep them unchanged.

Prices rose in line with expectations in August, keeping the inflation rate steady but well above the Federal Reserve's 2% target. 

The consumer price index increased 0.4% in August, according to the latest report from the Bureau of Labor Statistics, released Friday morning. Inflation rose 3.4% on an annualized basis, the same rate as July. 

The report confirms what Federal Open Market Committee members had been saying for weeks: that inflation is stuck stubbornly above target. But it still leaves considerable room for interpretation as to whether prices are moving up or down — and, by extension, whether or not inflation will come down without a rate hike. 

Core CPI, which factors out volatile categories like food and energy, was up 0.2% on the month and 2.4% year-over-year, a slight decline from July's 2.5% print. Energy prices have been driving overall inflation readings since war broke out between the U.S. and Iran in late February. But some policymakers say these shocks have not led to widespread price hikes. 

"I don't see elevated energy prices and tariffs now as a significant source of ongoing inflation pressure," Fed Gov. Christopher Waller said in a speech last week. "The evidence is that the price effects of tariffs have largely passed through inflation, and my earlier worry that higher energy prices would bleed into many goods and services prices hasn't come to pass, at least so far."

Waller, like other FOMC participants, said he would support keeping the federal funds rate at its current target range, 3.5% to 3.75%, if he perceived inflation to be falling. With core CPI at 2.4%, there is an argument to be that prices are moving in the right direction. 

In his speech, Waller also noted that a change in the calculation of the Bureau of Economic Analysis's personal consumption expenditure index, the Fed's preferred measure of inflation, could push the overall reading even lower.

"I don't like throwing out specific categories going into the estimate of PCE inflation, but nonmarket services prices have always been an issue for me, since they are imputed and not actual price changes," Waller said. "So, ignoring this one factor, my take is that underlying inflation is doing better than the core numbers suggest."

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The reading complicates financial market expectations, which have gravitated toward a rate hike in recent weeks. Two-year Treasury yields climbed to their highest level in more than two years while the federal funds rate futures market priced in a more than 90% chance of a hike shortly after the CPI release — up from around 73% on Thursday.

Markets have been volatile since the last FOMC meeting in July, but they had coalesced around a rate hike since Fed Chair Kevin Warsh delivered his keynote address at the Federal Reserve Bank of Kansas City's Jackson Hole Symposium on Aug. 28.

The speech has generally been interpreted as hawkish or more inclined to raise interest rates to combat high inflation. Warsh said inflation readings from June and July, while better than expected, did not amount to meaningful improvements in the pricing outlook. He also said he would support tighter policy, but only if inflation was demonstrably moving higher.

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

Whether Friday's CPI reading provides a clear enough picture for Warsh to support a move remains to be seen. In his Jackson Hole speech, he noted that during the past six months, 49% of the components in the personal consumption expenditures index, the Fed's preferred gauge of inflation, rose at least 3% on an annualized basis. Warsh described this saturation of high growth as "quite elevated" but said it was better than the 12-month window, over which 54% of PCE components were up 3% or more. 

The official PCE data for August will not be released until after next week's FOMC meeting. In the meantime, the onus is on Warsh and other FOMC participants to interpret how August inflation fits into the broader trend.

"We want to gauge whether underlying inflation is rising, falling, or stuck in place. We also want to understand not just the direction of travel, but also the speed," Warsh said. "Each of these broad inflation measures has fallen significantly from their 2022 heights. But progress over the past two years has been modest."

In his speech last week, Waller said he has seen underlying inflation trending down over the past three months at a speed that is "encouraging." He added that tariffs appear to have been a one-time shock to prices that is no longer accelerating inflation and increases to oil prices, while substantial, have not seeped into prices more broadly. Because of this, he said, he could be willing to allow rates to remain unchanged.

"To paraphrase John Lennon, I'm willing to give disinflation a chance," Waller said.

Other Fed officials echoed this openness to a hold. Fed Gov. Michael Barr said he would be willing to support keeping the federal funds rate unchanged if inflation appeared to be moving in the right direction.

"If trends in the data give me some confidence that inflation is moderating on a path to 2%, then I think we can take a bit more time to assess our policy stance," Barr said. "However, if inflation appears not to be moderating sufficiently, then I think we should act decisively to raise rates."

Meanwhile, other FOMC voters have been more weary of inflation, which has remained above the Fed's 2% target for more than five years now.

"I believe that we've been in an inflationary situation for more than five years," Federal Reserve Bank of Cleveland Pres. Beth Hammack said last month. "It's been running well above our target. I don't see any restriction in policy when I look at financial conditions and when I talk to market participants."

Hammack was one of three FOMC members to vote in favor of a rate hike in July. How that bloc reacts to Friday's CPI figures remains to be seen.

The FOMC meets Tuesday and Wednesday next week to decide on its next course of action for monetary policy.