The Fed Hikes Rates Amid Sticky Inflation and Strong Economic Data

With an economy running at full employment and growth remaining resilient with signs of strengthening, the Fed chose to address the inflation side of its mandate, which remains out of line with its 2 percent target. The Fed dot plot showed that 16 of the 18 participants expect at least one more rate hike this year, with four of those 16 suggesting the need for two more. In a shortened post-meeting press conference, a slightly hawkish Chair Kevin Warsh described the move as “removing a dose of accommodation.” He also revisited his comments from Jackson Hole, where he noted that he would be hard pressed to describe broad financial conditions as restrictive. Taken together, these sentiments point to a Fed that believes there will be a need to continue raising policy rates.

Many on Wall Street have suggested that recent price increases have been driven by supply shocks, so the Fed should not hike rates. We disagree. We believe that, regardless of the cause, 67 straight months of inflation above the Fed’s 2 percent target could cause expectations for relatively high inflation to become embedded in the actions of business owners and consumers. Chair Warsh acknowledged this possibility when he stated, “The plain fact is that inflation is too high and has been for too long,” adding that the Fed’s mandate is to ensure that “relative price changes in some sectors of the economy do not broaden, that inflation compensation in market prices stays low, and that inflation expectations remain well anchored.” Although the chair described this hike “as supporting a timelier return to 2 percent inflation,” the new dot plot shows that the Fed does not expect the return to be complete until 2029. This outlook keeps the risk of rising inflation expectations front and center.

Meanwhile, economic data this week supported the chair’s comments that economic growth appears to be strengthening. A strong and broad retail sales report showed conditions improving in 12 of the report’s 13 categories, with the control group increasing 1.4 percent after a -0.4 percent result the month before. Initial jobless claims also underscored the economy’s strength, falling back to 196,000. That figure was just above the mid-July low of 189,000—the lowest level since September 1969, when the U.S. labor market and overall population were substantially smaller. These reports continued a recent string of stronger data that has pushed the Atlanta Fed GDPNow growth tracker to 5.1 percent for the third quarter (though 2.3 percentage points are attributed to inventory rebuilding, which could create a headwind to fourth-quarter growth).

The economy’s strength is likely the reason the Fed felt comfortable raising rates. But we remind readers that rate hikes are designed to slow the pace of growth. They increase the risk of overtightening, because rate hikes have a delayed and uneven impact on the economy. Readers may remember that the Fed’s last round of rate hikes, in 2022 and 2023, contributed to a bifurcated economy, in which more rate-sensitive industries, companies, and consumers struggled even as the economy continued to grow. While the economy has broadened recently, the impacts from higher rates continue to weigh on some pockets of the economy. For example, the housing market has been depressed over much of the recent past and may deteriorate further with mortgage rates climbing near 7 percent. This week’s National Association of Homebuilders (NAHB) homebuilder optimism index fell to 32 from 35, nearing the post-COVID low of 31 in December 2022.

Despite strong growth, we believe the U.S. economy remains in a delicate balance. While retail sales have remained strong, underlying consumer fundamentals have weakened. Delinquency rates on credit card, auto, and student loan debt remain elevated. As we discussed last week, overall spending has become increasingly tied to higher-end consumers who have benefited from gains in the stock market. A pullback in inflation would help workers whose wages have been failing to keep pace with rising prices—a development Chair Warsh referenced when he said, “That way, when they get their wages, they can put their head above water.” Higher rates could work in the opposite direction by increasing borrowing costs, continuing to weigh on housing activity, and reducing equity market gains, which could slow the wealth effect that has supported spending by higher-income consumers.

These dynamics create risk and elevate uncertainty. After the rate hikes of 2022 and 2023 weighed on the interest-rate sensitive parts of the U.S. economy, two forces helped keep growth positive: a strong consumer, with balance sheets still bolstered by stimulus, and (most important) large increases in AI spending funded largely out of companies’ free cash flow. The backdrop looks different today. The consumer savings rate has fallen to 3 percent; the AI buildout is increasingly requiring large amounts of debt, making it more sensitive to higher rates; and concerns about AI safety could slow investment. These developments raise questions about how much cushion consumer spending and AI investment can provide moving forward. In addition, higher interest rates increase the cost of government debt. Higher debt costs pinch fiscal policymakers, who have continued to pump the economy full of stimulus. These factors lead us to continue positioning our portfolios for a very uncertain future.

We believe bonds play an increasingly important role in portfolio construction. While many investors are tempted to ignore fixed income, we believe it now offers compelling yields and could hedge against falling equity prices in the event of an economic slowdown. Since COVID, we have continuously stated our belief that the last mile of inflation would be the most difficult to complete, and that has proved to be the case. We believe bringing inflation down to 2 percent will take a series of hikes, not just one, increasing the chances of a policy mistake. We also note that the 10-year Treasury’s real yields—what an investor retains after accounting for expected inflation—are currently at 2.67 percent, their highest level since a few brief periods in 2006 and 2008 and, before that, 2002.

Equity markets have narrowed since late August, when higher oil prices led to a sharp rise in Treasury yields and investors started to price in a higher probability that September would kick off a rate-hiking cycle. Since the week that began August 24, only 26 percent of the companies in the S&P 500 have beaten the return of the overall index—an exceptionally narrow reading relative to the historical average of nearly 49 percent. The stock market’s advance has been dominated by stocks related to AI and the Magnificent 7, much as it was between 2023 and 2025. We question whether AI stocks will be able to buck the trend of higher rates if the AI-driven spending boom can no longer power the broader economy given its increasing interest-rate sensitivity and growing safety concerns.

Rather than chase an increasingly narrow group of AI-driven stocks, we continue to believe investors should focus on the broader opportunity set that could benefit as AI’s productivity gains spread through the economy. That broadening may not unfold in a straight line, and it may come with a hiccup if higher rates pressure the economy and markets. However, broader markets remain cheap on a relative basis, and history suggests that valuation support can drive intermediate- to longer-term relative outperformance. In our view, this environment reinforces the importance of diversified portfolios that are positioned not just for today’s narrow leadership but also for the broader market opportunities that may emerge over time.

Wall Street wrap

Retail sales show consumers continuing to spend

The Census Bureau reported that retail sales rose 1.2 percent in August after declining 0.5 percent in July, with 12 out of 13 categories gaining. Retail sales excluding the relatively volatile auto and gas categories also rose 1.2 percent following a 0.3 percent drop in July. The control group that is included in GDP calculations—which excludes food services, auto dealers, building materials stores, and gas stations—rose 1.4 percent on the month after falling 0.4 percent the month before, for a year-over-year pace of 5.6 percent.

Sales at non-store retailers (that is, online stores) rose 2.6 percent. The gain was largely attributable to the fact that Amazon’s Prime Day moved from July to June, which likely distorted the seasonal adjustment factor.

The strength and breadth of these numbers suggest that consumers on aggregate are continuing to spend amid weak real wage growth and a declining savings rate.

AI-related import prices jump

The government’s August Import and Export Prices data shows inflationary pressures mounting in certain areas, particularly those related to the AI buildout. Import prices as a whole were up 0.7 percent, raising the year-over-year increase to 7 percent. Roughly 1.5 percentage points of that increase came from fuel, which was up 26.8 percent year over year.

The AI buildout showed up in higher prices for imported capital goods, which rose 0.9 percent in August for a year-over-year increase of 7.3 percent. Rising prices for semiconductors pushed import prices from Taiwan, South Korea, Singapore, and Hong Kong up 12.6 percent year over year, and Canadian import prices were up 14.2 percent over the same period. Excluding computers, peripherals, and semiconductors—costs associated with AI—capital goods inflation was up just 2 percent.

Industrial production fell in August

The Federal Reserve’s August Industrial Production and Capacity Utilization report Friday showed production flat for the month, below consensus expectations for a 0.3 percent rise and down from 0.2 percent growth in July. Manufacturing is the largest component of the industrial production figure, and manufacturing production fell 0.3 percent in August—well short of expectations for a 0.3 percent gain and down 0.2 percent from the previous month. August was the first month with a contraction this year, and we think the decline is likely to be temporary.

Housing remains depressed

The NAHB released its latest sentiment index, in which a reading above 50 indicates expansion in the housing market and below 50 indicates contraction. The index fell three points to 32, barely higher than its lowest point this cycle (31, set in December 2022). The Current Conditions portion of the index fell four points to 35, with traffic of prospective buyers at just 23 and sales expectations falling six points to 37.

The week ahead

Monday: The Chicago Fed’s National Activity Index will kick off the economic week. Its 85 indicators offer insight into trends throughout the overall economy. We will be looking to see how growth is shaping up in the third quarter.

Tuesday: Payroll company ADP will issue its weekly National Employment Report. Initial jobless claims have been low recently, as noted above. We will be looking to see if the job market remains strong, in part because a healthy job market can make the Fed more comfortable raising rates to try to bring down inflation.

Wednesday: Standard & Poor’s releases its Global Purchasing Managers Index report, which includes voluminous data on employment, margins, and cost pressures at both services and manufacturing companies. With inflation looking sticky, we will be watching closely to see what manufacturing companies are saying about the prices they are paying and the prices they are charging.

Friday: The U.S. Census Bureau will release its Advance Report on Durable Goods, which will provide details about trends in business fixed investment. We will also be scrutinizing the University of Michigan’s final Consumer Sentiment report for September, after the preliminary report found that sentiment had plummeted to its second-lowest reading in the report’s history.

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company and its subsidiaries. Life and disability insurance, annuities, and life insurance with longterm care benefits are issued by The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM). Longterm care insurance is issued by Northwestern Long Term Care Insurance Company, Milwaukee, WI, (NLTC) a subsidiary of NM. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS) a subsidiary of NM, brokerdealer, registered investment advisor, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. Products and services referenced are offered and sold only by appropriately appointed and licensed entities and financial advisors and professionals. Not all products and services are available in all states. Not all Northwestern Mutual representatives are advisors. Only those representatives with Advisor in their title or who otherwise disclose their status as an advisor of NMWMC are credentialed as NMWMC representatives to provide investment advisory services.

A message from Advisor Perspectives and VettaFi: Discover something new! Click here to register for our upcoming webcasts.

© Northwestern Mutual Wealth Management

Read more commentaries by Northwestern Mutual Wealth Management