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Markets had largely laughed off the chances that the Federal Reserve will raise interest rates again this year, but economic data out on Thursday has forced investors to grudgingly admit it's possible. The headline US inflation rate had undershot expectations for five straight months, but it accelerated to 1.9% in August. A jump in gasoline and hotel prices following hurricane Harvey was the main driver. But the core inflation rate-- which strips out food and energy prices-- was also unexpectedly strong. Now, subdued inflation has been the primary reason why investors have been sceptical that the Fed would lift rates again. Although officials have blamed transitory, idiosyncratic reasons for that, that has become progressively harder to argue. As even New York Fed head, Bill Dudley, admitted last week, while some of this year's shortfall can be explained by one-off factors, his persistence suggests more fundamental structural changes may also be playing a role. So the August inflation reading will be welcome ammunition for the Fed hawks. The odds on a rate increase by December has climbed from a low of just 22% last week to about 47% today. The 10-year treasury yield duly edged up to 2.2% again, the highest since August 22nd.
Now, the market response is understandable, giving simmering concerns over the Fed's determination to start the slow but seismic runoff of its balance sheet, the European Central Bank's looming QE tapering, and subsiding fears of North Korea, the path of least resistance right now is to push treasury yields higher. Yet, the relatively muted reaction reflects the profound investor scepticism of the long term inflation and interest rate outlook. The inflation rate might have nudged higher in August, but hourly and weekly earnings growth both undershot expectations, dampening Thursday's treasury sell-off. Indeed Fed fund futures still imply that the Fed will raise rates just twice more by the end of 2018. So long suffering bond bearers will likely have to settle in for more pain ahead.
