Central bank doctrine recommends not reacting directly to a supply shock on the proviso that it is temporary and that inflation is not already persistently above its target. Currently, neither of these two conditions has been fulfilled. Underlying inflation, as measured by the PCE index, came in at 3.0% in August, and the US–Iran conflict has been dragging on for over six months.
Central bank doctrine recommends not reacting directly to a supply shock on the proviso that it is temporary and that inflation is not already persistently above its target. Currently, neither of these two conditions has been fulfilled. Underlying inflation, as measured by the PCE index, came in at 3.0% in August, and the US–Iran conflict has been dragging on for over six months.
Energy prices increased in September, while the prices of refined oil products in the United States have risen more than their historical correlation with oil prices would suggest. While the rise in the price of oil is weighing on global inflation without necessarily affecting prices more generally, the price of diesel could feed into underlying inflation. Diesel will directly fuel cost increases in the agriculture, construction and transport sectors. Furthermore, as regards businesses’ intention to raise their prices to preserve their margins, the risks of contagion are very much real.
Nonetheless, any spread of overall inflation into core prices (i.e. excluding energy and food) will only materialise if demand lets it. Today, US consumer spending is holding up well, as seen by August’s data for retail sales and new orders in the service sector, which have reached a multi-year high according to the Purchasing Managers’ Index (PMI). This means that there is fertile ground for inflation to spread and the Fed has got the message. Does this mean, then, that the Fed will have to raise its rates by nearly one percentage point within a year, as the money markets are expecting? We do not think so for two reasons.
First, the rise in oil prices will naturally put the brakes on some demand; any such rise acts as a tax on low-income households for whom energy costs absorb a larger part of their budgets. Consequently, consumers will struggle to cope with a rise in prices, which will reduce the pricing power of firms in the affected sectors. Next there is the fact that there is nothing to indicate that price rises will be met with similar wage rises. In order for inflation to persist in services, there would have to be a price–wage loop. However, the US employment market is neither hiring nor firing to any great extent, and wage growth is currently slowing down. Without this driver, any sustained increase in core inflation seems unlikely. These two arguments thus call for the Fed to tighten rates more gradually than the money markets are expecting.
The Fed has been right to soften its stance: faced with a shock that is threatening both price stability and its credibility, waiting would have risked committing the same mistake made in 2021. Looking ahead, rising oil prices and the slowdown in wage growth argue in favour of limited monetary tightening. According to our scenario, the money markets are crediting Kevin Warch with being too much of a firm hand, without yet fully understanding how he reacts to key economic indicators.
The opinions expressed herein are correct as at 01 October 2026 and are subject to change without notice. This information should not be relied upon by the reader as research or investment advice regarding any particular fund, strategy or security. Past performance is not a guide to current or future results. Any forecast, projection or target, where provided, is indicative only and is not guaranteed in any way.
