Market Pricing Shifts Toward Federal Reserve Interest Rate Hikes Amid Inflation Concerns

A swell of unfriendly factors for inflation likely will push the Federal Reserve to an interest rate hike next week and there's possibly another before the end of the year, judging by market pricing Thursday.

Traders pushed chances for a rate increase to 70% in morning action, following a report showing increasing wholesale prices in August and a coincidental jump in U.S. crude oil prices past $100 a barrel, according to the CME Group's FedWatch gauge.

They also nudged chances of another increase in December to close to 60% as inflation dynamics are providing stubborn and more likely to generate a central bank reaction.

"As the conflict with Iran drags on longer than many expected, inflation pressures are becoming increasingly entrenched, leaving investors in search of a catalyst strong enough to change the inflation narrative," wrote Jeffrey Roach, chief economist at LPL Financial. "At this rate, a hike in rates next week appears likely."

The producer price index, a measure of wholesale and pipeline cost pressures, rose 0.4% in August. Though that was in line with forecasts, it followed an upwardly revised 0.1% increase in July, together pushing the annual PPI level to 5.4%, slightly higher than forecast.

At the same time, intensified hostilities in the Middle East spooked commodities traders, sending U.S. crude up 4% to just over the $100 barrier.

Finally, the European Central Bank announced a quarter percentage point hike and raised its inflation forecast on worries that the Iran war would have deeper economic impacts and inflict a longer-term hit on consumer prices.

"More pressure is coming because crude and refined products have kept rising since the August data was collected," said David Russell, global head of market strategy at TradeStation. "The ongoing spike in oil, combined with low jobless claims, make it hard for the Fed to not hike next week."

Bank of America senior U.S. economist Stephen Juneau estimated that, accounting for the August PPI reading, core PCE is tracking at a 0.26% monthly rate, which would get rounded up to 0.3%.

"This could move significantly tomorrow after CPI, but if we are correct, it should greenlight a hike at next week's Fed meeting," Juneau said in a note.

BofA has one of the most hawkish Fed forecasts on Wall Street, expecting three hikes at upcoming meetings.

While that's out of consensus with current futures pricing, recent developments point to a more aggressive Fed when it comes to inflation fighting.

Peter Boockvar, chief investment officer at One Point BFG Wealth Partners, said that even a soft CPI reading might just indicate that companies are having a harder time passing through higher prices to consumers.

"Those who just look at consumer prices for their inflation information and interest rate predictions are not looking at the complete picture, and today's PPI is evidence still of an inflation problem throughout the supply chain," Boockvar said.