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With only a week to go before a pivotal Federal Reserve monetary policy meeting, the outlook for interest rates has been rattled yet again.

On Tuesday, the Labor Department reported consumer level inflation broadened in August after some recent data had pointed to the possibility that the worst of the price pressure surge had crested. The consumer-price index rose 8.3% last month from a year earlier and core CPI, which excludes food and energy, increased by 6.3% over the same period.

Additionally, Fed data showed that the underlying level of pressure in the widely watched consumer-price index also took a turn for the worse. The Federal Reserve Bank of Cleveland said Tuesday its Median CPI, which strips out the biggest categories of price changes in a given month, increased 6.7% in August from a year earlier, up from the 6.3% year-over-year rise in July.

The CPI data splattered financial markets and drove some observers to upsize already aggressive interest-rate rise forecasts for the rate-setting Federal Open Market Committee meeting scheduled for Sept. 20 and 21. Going into Tuesday, markets had already absorbed a raft of hawkish Fed commentary and converged on an expectation the Fed would lift its now 2.25% to 2.5% federal-funds target rate range by 0.75 percentage point, a big move that would match increases in June and July.

Now, some banks like Nomura believe the Fed might raise rates by a full percentage point. Harvard University’s Lawrence Summers, a former Treasury secretary who has frequently criticized Fed policy, said on Twitter that, “it has seemed self evident to me for some time now that a 75 basis points move in September is appropriate. And, if I had to choose between 100 basis points in September and 50 basis points, I would choose a 100 basis points move to reinforce credibility."

In trading late Tuesday, the CME Group Fedwatch tool showed markets giving a 34% chance for a full percentage point increase. Before Tuesday, markets didn’t put real odds on a move of that size.

If it were only for inflation data, the case for the Fed and its rate path would be clear-cut. But a report from the New York Fed on Monday told a different story about price pressures.

The report said a survey in August found households expect weaker future levels of inflation at the one-, three- and five-year horizons. While a decline in the projected path of gasoline prices was a big influence on the overall easing, survey respondents also saw softer rises in other key price categories such as for homes, rent and food.

Weaker inflation expectations matter to the Fed because its officials believe—even though some of its economists don’t—that where the public expects inflation to go in the future exerts a strong influence on where it is now. The New York Fed data, borne out in other inflation expectations measures, suggests that at some point price pressures should begin easing.

Top Fed officials have been able to derive some solace from stable longer term inflation expectations readings, seeing them as a vote that the public doesn’t anticipate a lasting surge in inflation.

But with current levels of inflation failing to cool, Fed watchers will need to keep a close eye on expectations data. If it reverses course, it could add even more spine to a hawkish monetary policy outlook and help push the Fed toward a more aggressive path of rate rises.

 

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