Could the "87% chance of a rate hike" be a market misjudgment? Institutions: The Fed may still hold steady this week.

Michael R. Strain, director of economic policy studies and a senior fellow at the American Enterprise Institute, said that despite high rate-hike odds priced into financial markets, the Fed is unlikely to raise rates at its September meeting. Strain said the "center of gravity" on the Federal Open Market Committee (FOMC) still favored keeping rates unchanged at the July meeting, and he does not believe economic data published since then have been strong enough to materially change that view. Strain acknowledged that the August consumer price index (CPI) report may have pushed some FOMC members toward supporting a rate hike, but he argued that the data would need to be markedly more concerning to prompt the Fed to begin a new rate-hike cycle. He noted that markets price an 87% probability of a rate hike, but the appropriate question is not whether the Fed should raise rates this week, but whether it should begin a rate-hike cycle. He added that the possibility of a one-off rate hike would create a separate communication challenge for Chair Warsh, who may be reluctant to explain why the Fed carried out its first isolated rate hike in decades. Strain said that, at the same time, the August inflation data may not be as concerning as the market reaction suggested. Based on the CPI report, he expects August core PCE inflation to accelerate from June and July but still come in around a 3.1% annualized level, with the six-month change in core PCE at about 3.2% annualized. If those estimates hold, Strain believes most FOMC members may still see the data as consistent with continued disinflation rather than a substantive reacceleration of inflation. August core services CPI was 3% year over year, unchanged from July, offering little evidence that underlying services inflation is reaccelerating. Strain also argued that financial conditions have tightened over the past few weeks, potentially accomplishing part of the work that would otherwise have required a higher federal funds rate. He said that while avoiding a negative market reaction may be one consideration for policymakers, a one-off rate hike would itself run counter to market expectations, with the bond market pricing about a 75% probability of two or more rate hikes in 2026. Therefore, unless the Fed intends to signal that its policy approach under Warsh will differ from that of his recent predecessors, a rate hike could still surprise the market. Although Strain expects the Fed to keep rates unchanged this week, he said he personally leans toward a hike. He believes the federal funds rate is too low, saying he would have voted for a hike in July and opposed the Fed's 2025 rate cuts. However, he does not think most FOMC members have materially changed their assessment since July, so he expects the Fed to keep rates unchanged this week, while acknowledging he "would not be shocked" if the Fed ultimately raises rates.