The holiday-shortened week proved to be eventful, with U.S. Treasury yields flirting with their post-pandemic peak (Chart 1) and oil prices briefly breaching $100/barrel for the first time in four months. The two developments are partially related, as rising energy costs have bolstered expectations for tighter monetary policy. However, a higher term premium has also played a role, reflecting increased compensation demanded by investors to hold longer-dated U.S. government debt (see here). Against this backdrop, equities struggled, with the S&P 500 down 0.7% on the week as of the time of writing.

Energy prices marched higher throughout the week as tensions between the U.S. and Iran flared up periodically but paused on Friday amid signs of diplomatic efforts between Iran and several Gulf states to reopen the Strait of Hormuz. Many of the factors that helped to contain energy prices through the summer, both domestically and internationally, are no longer providing the same degree of support. As the recent rise in oil prices illustrates, this could leave energy prices more vulnerable to any further escalation in geopolitical tensions.

August’s CPI inflation data released on Friday only captured a modest uptick in energy prices during the month, but it was still sufficient to generate an acceleration in headline inflation. The producer price index rose 0.4% in August, bringing the annual change to 5.4%, as higher energy costs filtered through supply chains. In the six months since the start of the conflict in the Middle East, producer prices have risen by 2.7%, compared with a 2.0% increase in consumer prices. If this gap reflects margin compression, the recent increase in energy prices could generate greater pass-through to consumer prices if sustained.

On the consumer side, headline and core inflation accelerated to 0.4% and 0.3% month-on-month respectively. The energy price driven uptick in headline inflation was expected, but the acceleration in core inflation, which included broad increases in prices for airfares, hotels, and communication services, was an unwelcome surprise. While the three-month annualized change in core prices sat at 2% in August, the acceleration recorded in both goods and services was more concerning(Chart 2).

Taken together, this week’s data paints a complicated picture for next week’s Fed interest rate decision. Inflation pressures have undoubtedly trended higher, which seems likely to continue into September with oil prices up roughly 16% since the end of last month. However, energy prices remain volatile and the near-term acceleration in core inflation is young. Combined with the sustained stability in inflation expectations, next week’s decision is likely to be a close call. Markets appear slightly more confident, with odds for a hike next week jumping from roughly 70% to 90% following the CPI data release. Chair Warsh’s post-meeting press conference and the updated summary of economic projections will be of particular interest, as markets assess the evolution of the Fed’s reaction function in an environment of elevated uncertainty. We will be releasing updated economic and financial forecasts the following day.