This week, we will hear from the Fed as they announce the next rate hike on September2 1st. It will be big too. Just how big is a matter of debate. 0.75% is a safe starting point, but 1.00% will be on the table as well. The former would match July’s hike–the biggest since 1994. A 1.00% hike hasn’t been seen since 1982.

Desperate times call for desperate measures, and the Fed is desperate to push back against the highest inflation in decades.

The Consumer Price Index (CPI) is the oldest and most widely-followed measure of overall inflation in the US. The Fed targets an inflation rate of 2.0% at the core level. That mission
was going about as well as it had ever gone for most of the past 2 decades until covid. For a variety of reasons, the Fed dragged its feet a bit in responding to post-covid inflation
threat and has since been scrambling to catch up.

That “scramble” is evident across financial markets. The typical reaction for stocks and bonds alike is to SELL SELL SELL when the Fed sends unfriendly messages. When
traders sell bonds, rates rise. Stocks obviously move lower when sellers are in control.

What are the “unfriendly messages” and the “shift in the Fed policy outlook” specifically? Back in January, the big wake-up call was the Fed’s clear communication that its rate hike
timeline would play out much more quickly than it did during the 2013-2018 tightening cycle. As Fed speakers made that increasingly clear via speeches and official policy
communications, stocks and bonds continued to freak out.  Once the market feels like it understands the Fed’s mindset, it doesn’t wait around for such speeches. If traders know the data that the Fed cares about, traders will react to the data itself. In the current case, things are fairly simple because inflation has no other competition for the Fed’s focus. When last week’s CPI data came out hotter than expected, traders knew what to do.

Thankfully for consumers, the data actually didn’t show much of an increase in overall monthly obligations.

The headline number includes every price collected in the CPI report. It didn’t rise at all in July and only rose 0.1% in August. That’s the good news. The bad news is threefold. First, it was only as low as it was due to declines in fuel prices. Second, the Fed famously focuses on “core” CPI, which excludes food and energy.

We find the third piece of bad news in the data itself where Core CPI defied forecasts by a wide margin, surging to 0.6% versus expectations to hold steady at 0.3%.

Obviously, if every month was increasing at 0.6%, that would leave us at 5.0% in annual terms! Hence the sense of urgency in financial markets and the ramped up expectations
for next week’s rate hike.

Now’s a good time to answer the headline question of “what really matters?” While it’s true that the market could experience a lot of volatility next week if the Fed hikes by 1.0% instead of 0.75%, traders have been making much bigger changes to the Fed’s rate hike outlook for the subsequent meetings.

How can traders change the Fed’s rate hike outlook? They don’t, really. They simply make bets as to where the Fed Funds Rate will be after any given month’s Fed meeting.

The market got its hopes up for a friendly rate scenario by late July and has been forced to do an abrupt 180° since then, both due to economic data and inflation reports. Last week’s
was just the latest example. It happened to have an outsized impact because it’s a highly uncertain time for inflation. Economists are looking for signs (and in some places, seeing
them) that inflation has turned a corner.

They were also worried about the possibility that those positive signs were merely byproducts of plummeting oil prices. Last week’s core CPI data says that worry is valid. It
doesn’t help that Fed speakers are in their blackout period (12 days without Fed speeches  leading up to an official policy statement) and that almost all of them have said they would
let data determine the size of the next hike.

But to reiterate, it’s still not the size of next week’s hike that matters most. What matters most (or at least more) in no particular order will be the Fed’s own rate hike outlook. This is conveyed in the Fed’s “summary of economic projections” or SEP. The SEP is released at 2pm along with the rate hike announcement. It frequently moves markets far more than anything in the announcement itself, and thus frequently leads to the faulty conclusion that the market is responding to the Fed’s rate hike.

In the case of the current meeting, the rate hike actually has more market moving power than average due to the uncertainty on the size of the hike.

Let’s connect the dots, briefly, to how this has impacted the mortgage market. Here too, it’s not the Fed Funds Rate itself or the short term outlook that matters as much as the longer term outlook. The Fed has also fully exited its bond buying programs as of September 15th. Although that dagger in the heart had been planned for months, daggers still hurt. Fed bond buying had been a major source of downward pressure on rates until they began to taper their buying amounts in late 2021.

So, congratulations! You’re living through an era that hasn’t been seen in more than a generation when it comes to the persistence of exceptionally high volatility (it was briefly a bit higher for small pockets of time in the past, such as March 2020, but it hasn’t been this elevated for this long since in 40+ years).