Core Inflation Fell. Why Did the Probability of a Rate Hike Rise?

August CPI data were released last night. Annual core inflation fell from 2.5% to 2.4%, yet the market-implied probability of a September rate increase jumped from 71.3% to 88.8%. Why did expectations of tighter policy strengthen as inflation fell? The answer lies in the monthly figure, rather than the annual one.

What Is Core Inflation?

Core inflation measures prices excluding food and energy, the most volatile components. August core CPI rose 2.4% year on year, its lowest rate since March 2021. But the monthly increase was 0.3%, above the previous 0.2% and above the 0.2% expected in both the Dow Jones and Reuters surveys. It was the largest monthly increase since April this year.

Headline CPI inflation was 3.4% year on year, unchanged from July, and 0.4% month on month. Headline inflation did not fall alongside core inflation largely because petrol rose 3.9% over the month and energy rose 2.1%, supporting the overall reading. The downward trend in core inflation becomes clear only when those two components are set aside.

Why Can Annual and Monthly Inflation Move in Opposite Directions?

The annual rate covers a rolling 12-month period. When a month with a large price increase drops out of that window, annual inflation falls. Prices can therefore rise faster in the latest month even as their cumulative increase over 12 months slows. But the market currently places more weight on the most recent month: the effect of the 0.3% monthly reading far outweighed the decline in annual inflation.

What Pushed the Probability Higher?

August CPI was a particularly important release ahead of the September 15–16 FOMC meeting. After it was published, the rate-futures market’s probability of a September increase jumped from 71.3% on the day before the CPI release to 88.8%.

The main driver was not the level of inflation itself, but the direction of the surprise relative to expectations. Fed Governor Waller’s September 3 remarks also highlighted this logic: with policy only slightly restraining consumer and business demand, it would not take much acceleration in inflation for him to support an increase.

Another Measure: PCE

The Fed focuses on headline PCE inflation rather than CPI. In July, headline PCE inflation was 3.7% and core PCE inflation was 3.34%, both above the 2% target. This CPI release covered August; August PCE data would not arrive until September 30. Core CPI and core PCE are not calculated in the same way, although most PCE components are derived from CPI data.

What Needs Continued Attention?

August’s figures clearly did not support either extreme conclusion—that inflation was solved or that it was out of control. Markets trade changes at the margin. Establishing a trend requires subsequent, consistent data measured on the same basis.

A decline in annual inflation is encouraging, but the monthly reading still offers little reassurance to markets.