Globally, stocks gave back recent gains as a disappointing U.S. inflation report served as a wake-up call that central banks are likely to tighten further. The MSCI All Country World Index tumbled 4.1% while the S&P 500 slumped 4.8% and the Dow Jones slipped 4.1%. The tech-heavy NASDAQ dropped 5.5% as interest rates ratcheted higher with the 10-year U.S. Treasury yield climbing 14 basis points to 3.45%.
The August consumer price index (CPI) report showed headline inflation falling from 8.5% to 8.3% as energy prices eased. However, higher prices for shelter, food, and used cars pushed core inflation up – from 5.9% to 6.3%. As a result, financial markets quickly priced in another 75-basis-point rate hike from the Federal Reserve at its September meeting and a terminal fed funds rate north of 4.0%.
It is clear now that hopes of a “Fed pause” in September were premature. While inflation appears to be headed in the right direction, the Federal Reserve seems to believe that further rate hikes are needed. It remains an open question of whether a fed funds rate of 4.0% to 4.5% will be restrictive enough to bring down inflation to the Fed’s 2.0% target, but we do think the Fed may eventually go into a holding pattern at some point in 2023 as it waits to see the delayed impact of its recent monetary policy tightening.