Cheng

I do not think the Fed hikes next week. Everyone is looking at the market pricing, which puts roughly 90% odds on a hike. Everyone is looking at the 3.4% headline CPI and the 0.4% monthly print. And the conclusion seems obvious: the Fed has to hike. I disagree. I think the market is overreacting to an inflation number that deserves significantly more context. Let's start with the most important chart. CPI excluding food and energy is now running at roughly 2.4% year over year, close to the lowest level we've seen since 2021. Importantly, the long-term trend remains dramatically lower than the inflation spike of 2022–23. The underlying inflation problem that originally forced the Fed into aggressive tightening is simply not what it was. The headline number looks much worse because energy prices are exploding. Gasoline rose 3.9% in August alone and is up 27.4% year over year, while the overall energy index rose 2.1% month over month and 16.3% year over year. Gasoline alone accounted for more than one-third of the entire monthly CPI increase. That's an enormous distinction, because higher oil prices are not the same thing as an overheating U.S. economy. You cannot raise interest rates and produce more oil. You cannot raise interest rates and reopen a disrupted shipping route. You cannot raise interest rates and make gasoline cheaper when the underlying problem is a supply shock. What higher rates can do is make mortgages more expensive, increase credit-card costs, raise business financing costs and discourage investment. In other words, the Fed would be using demand destruction to fight a supply shock, and that's a dangerous policy response. There's another part of the picture I think the market is underappreciating: the labor market. Yes, August payrolls increased by 162,000, but that number needs context. June was revised from +20k to +31k and July from -23k to +21k, so the two months combined were revised 55,000 jobs higher than previously reported. That's better than initially reported, but it isn't evidence of an economy that is overheating. The unemployment rate is 4.1%. Average hourly earnings are growing only around 3.1% year over year, the slowest pace since 2021 according to recent reporting. Weekly initial jobless claims are sitting around 206,000, hardly evidence of a labor market suddenly spiraling out of control. This looks much more like a labor market that has stabilized than one generating an inflationary wage-price spiral. This is where the Fed has to be careful. The mandate isn't "get headline CPI to 2% at any cost." The Fed has to balance price stability with employment. If inflation is being pushed higher by energy while the underlying economy isn't overheating, deliberately weakening employment to fight that inflation may be counterproductive. There's also an interesting signal that came directly from the Fed. Governor Christopher Waller recently said that, if the improvement in the incoming data continued, he would be inclined to hold the federal funds rate at its current level, while explicitly leaving the door open to a hike if the improvement proved fleeting. That matters, because the August CPI report didn't suddenly reveal an economy experiencing runaway demand. It revealed energy inflation, some sticky services inflation and relatively contained underlying inflation. Core CPI did rise 0.3% in August, so I'm not pretending the data was perfect. But even with that print, core CPI is 2.4% year over year, a very different situation from 2022. PPI deserves similar scrutiny. Headline PPI increased 0.4% month over month in August and 5.4% year over year, which sounds terrible at first glance. But the composition matters. Final-demand goods prices increased 1.1%, while final-demand services increased only 0.1%, and a major contributor to the goods inflation was energy: diesel prices jumped 24.1% in August. We're seeing the same story repeatedly. Oil feeds into diesel, which feeds into transportation, producer prices, gasoline and ultimately CPI. That is not the same thing as consumers suddenly spending so aggressively that the economy cannot keep up. This is why I think the market may be making a mistake. The market is looking at the level of inflation; the Fed should be looking at its source and persistence. If the inflation shock is temporary and supply-driven, hiking rates doesn't solve the underlying problem. It simply makes the demand side weaker. And there is already evidence that consumers are feeling the pressure: real wages have been under strain, with inflation outpacing nominal wage growth in recent months. So imagine the policy response. Energy prices rise because of a geopolitical supply shock, and real purchasing power falls. Then the Fed responds by making credit more expensive. Mortgage costs rise, business financing costs rise, investment slows, consumption slows, hiring slows. And the underlying energy problem is still there. That's not necessarily a good trade. Then there's the elephant in the room: financial conditions. The 10-year Treasury yield is already approaching 5%, and mortgage rates have moved above 7%. Long-term borrowing costs are already doing a significant amount of tightening for the Fed. The Fed doesn't operate in a vacuum, and if financial conditions have already tightened substantially because of higher oil prices, higher Treasury yields and higher borrowing costs, the case for immediately adding another 25 basis points becomes less compelling. And then there's the constraint nobody at the Fed will say out loud: the federal debt. The U.S. is carrying more than $37 trillion in debt, and net interest costs are now running well above $1 trillion a year. That's more than the entire defense budget. It's one of the largest line items in the federal government, and it is growing faster than almost anything else. Every 25 basis points the Fed adds doesn't just hit mortgages and credit cards. It flows directly into the cost of rolling over trillions of dollars of Treasury bills and notes that mature every year and have to be refinanced at whatever rate the market demands. This is the part of the rate debate that gets treated as taboo. The Fed insists it doesn't set policy with the Treasury's borrowing costs in mind, and officially that's true. But the math doesn't care about the official line. A large share of the debt was issued when rates were near zero, and it is steadily rolling into a 4–5% world. Higher policy rates mean higher bill yields, higher coupon payments and a deficit that widens even if Congress doesn't spend a single additional dollar. The government ends up borrowing more just to pay the interest on what it already borrowed. That's a feedback loop, and it's one that a rate hike makes worse, not better. There's a name for this: fiscal dominance. It's what happens when the debt load gets large enough that monetary policy starts being shaped by the government's financing needs rather than by inflation alone. The Fed would never admit it's operating under those conditions. But look at what a hike does in practice. It raises interest costs, which raises deficits, which raises Treasury issuance, which pushes long-term yields higher still. The 10-year is already flirting with 5%. Adding fuel to that from the short end, in an economy where the underlying inflation trend is 2.4%, doesn't look like sound risk management. It looks like a policy choice that makes the country's biggest structural problem more expensive to carry. So when people say the Fed "has to" hike, I'd turn that around. The Fed has to weigh a supply-driven inflation print against the reality that it is the central bank of the world's largest debtor, and that every hike is, in effect, a tax on the Treasury paid to bondholders. That doesn't mean the Fed can never tighten again. It means the bar for tightening into an oil shock, with the labor market cooling and the government's interest bill compounding, is a lot higher than a 90% market probability suggests. The key point is that the Fed can wait. There is no reason it has to respond to every single inflation print immediately. It has another meeting, another month of inflation data, more labor-market data and more information about oil. If inflation is genuinely accelerating because of domestic demand, the Fed can hike later. But once you hike, you can't un-hike the economic damage that comes with it. So why rush, especially when the market is already pricing near-certainty? That is what makes this setup interesting to me. The market is pricing the hike as if it is inevitable, but the actual data is far more nuanced: headline CPI at 3.4%, core CPI at 2.4%, gasoline up 27.4% and energy up 16.3% year over year, August gasoline up 3.9% month over month, unemployment at 4.1%, August payrolls at +162k, wage growth around 3.1% and initial claims at 206k. This isn't a perfect economy, but it also doesn't look like one that suddenly requires emergency monetary tightening. That's ultimately my view. I don't think the Fed needs to hike next week. The market has become too focused on the headline CPI number and not focused enough on what is actually causing it. If inflation is primarily being driven by energy and supply-side pressures, the Fed risks fighting the wrong battle. And if the underlying inflation trend is still moving toward 2% while the labor market is stable rather than overheating, there is an argument for patience. The contrarian trade here isn't "inflation is dead." It is "inflation is not accelerating enough, the economy is not overheating enough, and the government's interest bill is already too large, to justify rushing into another hike." The market currently sees roughly 90% odds of a hike. I think that probability is too high. And if the Fed chooses to hold next week, that would not be a dovish policy mistake. It could simply be the Fed recognizing that you don't fight an oil shock with a sledgehammer.

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