Why the Fed May Be Raising Rates

Full transcript:

Hello and welcome to this month’s market update. My name is Steve. I am the chief investment officer for Bernicke Wealth Management. Today we’re going to be talking about the Federal Reserve and the rate hiking expectations that are currently baked into the market. We started the beginning of the year in 2026, with the expectations that the fed was likely to cut interest rates for the remainder of the year.

Six months in. We’re starting to find that story has changed primarily as a result of inflation related concerns. So let’s jump into a couple charts to see exactly what is going on

the chart that we have in front of us. Here is a prediction chart, or more accurately, a chart of what the market anticipates the Federal Reserve will do in the following series of meetings.

What the Market Predicts for the Next Few Fed Meetings

On the left hand side, over here, we have all the future meeting dates going back out to December 2027, and the next meeting the fed has is at the end of this month, July 29th. Right now, the market is anticipating about a 75% chance that interest rates will stay in their current range of 3.7 or, excuse me, 3.5% to 3.75%.

However, if you go to the next month’s meeting in September, we now find that the market is anticipating a 76% chance that the Federal Reserve will increase interest rates to 3.75%, up to 4%. That would be a .25 percent increase in interest rate expectations. Now, if we go out even further all the way to March of 2027, the market then anticipates another rate hike of 0.25%, bringing the overall target to 4 to 4.25%.

Now, the further out you go, obviously the more dynamic these predictions are. Obviously, there’s a lot of data that comes in play whenever we’re looking at what the Federal Reserve might do. But the reason why the market’s anticipating rate hikes for the next couple of meetings is because of inflation. And the Federal Reserve has a dual mandate.

Inflation and the Fed’s Dual Mandate

Price stability, which is inflation, stability and employment or full employment, making sure that jobs are plentiful and markets and businesses can have employees working the jobs and remaining productive on the lines. And so what we want to look at right now

is where our inflation expectations are and what the overall inflation picture looks like. And if we go back over the last ten years, what we can see here is our inflation data points.

Now these three lines represents three different measures of inflation. The purple line being the PCE which is the preferred measure the Federal Reserve looks at for inflation. The orange line is the consumer price index which is the overall inflation measure. The government tends to use and highlight. And then we also have the core PCE, which basically strips out more volatile measures like energy and food items.

And all of these tend to move in the same direction. And so for the beginning of the five years on this chart, going back to 2016, all the way up through Covid, we saw inflation moving somewhat in lockstep. And then obviously we had the big inflationary pressures in the middle of 2022, and then they receded in 2023, coming down to near levels where we’re at in 2024 and moving into 2025.

How the Fed Fought Inflation Post-Covid

The chart below shows what the Federal Reserve was doing in order to battle those inflationary pressures. Now, beginning in Covid, we had the Federal Reserve cut interest rates all the way to zero really fast to stimulate the economy. What we now know in hindsight is that the stimulation overheated the economy which led to inflation, which is then why the Federal Reserve increased interest rates so significantly, so quickly during 2022 and into 2023.

We’ve since had interest rates cut a series of times to get to our current rate of 3.5 to 3.75%. Now, the concerning measure and the reason why we’re talking about interest rate hikes is because of this data right here, right into 2026. We’re starting to see inflationary pressures pick up. And it’s not just headline numbers like the PCE or the Consumer Price Index.

The CPI, which do include volatile items like energy and food. We’re also seeing that increase with the core, which is specifically focused on more stable items that are purchased on the good side and on the services side. And so what does that mean from the Federal Reserve standpoint? Well, they tend to ignore a lot of the volatility of energy prices.

For the most part, if energy remains high for a long period of time, then they might start to consider that from an inflationary perspective. But because they know energy prices tend to be quite volatile, especially when tied to geopolitical activity, they tend to brush that aside and look at the core services and goods and what that inflation picture looks like.

Breaking Down Goods vs. Services Inflation

And our final slide here breaks that down. So what you’re seeing here is a breakdown of inflation of goods and services. Now this does include energy. And the reason why we wanted to keep energy in there is to show you how volatile that can be on the good side. And just to break down what that means, goods are kind of like tangible products.

So it’s cars, it’s furniture. It’s being able to go out and buy tangible items. And again, energy and food stuff is going to be in there as well because that’s what we bring home, use, consume, eat and so forth. Services are more financial services. It’s staying in a hotel. It’s buying a plane ticket. It’s going to a sporting event.

It’s going out to eat. Those services make up about 60 to 70% of our overall economy, and that makes up a bulk of our inflationary measures as well. So when we look at goods versus services on inflation, we want to be very careful of how we’re breaking that down, because it does matter based off of how much weight it garners in the overall inflation reading.

Now the goods line is the blue line, and the orange line is the services line. And we can see right at the beginning of 2026, goods inflation was effectively zero year over year. However, once the Iran war started, we saw that inflation pick up significantly and a majority of that increase was related to energy. Now on the other side with services, services actually tick down a little bit where we saw overall inflation come in from 12 months prior.

However, since then we’ve started to see that tick up again. Even though energy is coming down, services is going up. And because services represents a larger portion of our inflation readings, that’s beginning to outweigh the disinflation from reduced energy prices.

That’s really, in our opinion, what the Federal Reserve is focused on right now is how much of that inflationary pressure is transitory, meaning something that we anticipate falling off because the Iranian war might be more subdued, although that is still in flux as well.

Or is this more permanent because a number of the inputs, especially computer based inputs like RAM prices, GPU, CPU prices, all tied to artificial intelligence build outs have inflated significantly. How much of that gets passed on to the end consumer, and can that be recouped either through efficiencies or lower prices? Right now, the inflationary data is suggesting that it’s a pricing pressure on the upside and not so much one on the downside.

That’s why the Federal Reserve is likely to hike rates here in the next couple of meetings, just to show that they are focusing on inflation, and they want to bring inflation back down to their 2% target.

That’s all for this month. If you have any questions, please don’t hesitate to reach out. We’re always happy to answer them for you.

Thank you very much.