The U.S. Federal Reserve delivered on consensus expectations by raising its policy rate by 25 basis points (bps) at its September meeting. The Federal Open Market Committee (FOMC) also shared updated forecasts in the Summary of Economic Projections (SEP), sending a strong signal that September’s rate hike will very likely be followed by another hike this year, and possibly an additional hike in 2027 if inflation doesn’t moderate quickly enough.
The FOMC statement explained the move as an action to “support a timelier return to the Committee’s 2 percent goal.” While a range of underlying inflation measures suggest that inflation is moderating back to target, the Fed’s preferred measure – core Personal Consumption Expenditures (PCE) – has reaccelerated and is currently running above a 3% annual pace. Headline inflation has also risen along with higher energy prices.
The outlook for energy is unusually uncertain, as geopolitical tensions continue to keep energy prices elevated and volatile. However, unless energy prices increase materially, headline inflation is likely to be much closer to target by next spring, as the initial energy price shock at the outset of the Iran conflict begins to drop from the year-over-year calculation. (This is referred to as the base effect.) Going forward, this may alleviate some pressure on the Fed.
In his press conference, Chair Kevin Warsh described the move as removing a “dose” of accommodation to achieve a timelier return to 2% inflation. Warsh’s description is a departure from other FOMC members’ characterizations of policy as neutral to slightly restrictive, and it suggests that he views rate hikes as something more than purely managing the risk that inflation expectations drift higher. When asked to reconcile the FOMC’s goal of a timelier return to 2% inflation with the median SEP projection that core PCE inflation will not return to target until 2029, Warsh responded that the projections were not his forecast, and that he is serious about delivering on the price stability objective. In other words, Warsh may favor a more restrictive policy stance than the SEP projection of two 25-bp hikes by the end of 2027 (including this hike just announced in September) in order to return inflation to 2%.
Inflation progress has slowed
The Fed’s decision to hike appears to be a response to slower progress toward the Fed’s 2% target over the last few years, as a series of supply shocks and one-off price adjustments related to tariffs, energy supply, and AI-related demand have lifted inflation. Typically, the Fed would look through these shocks. However, with inflation persistently elevated and strong demand-side factors supporting the economy due to post-pandemic wealth gains, the Fed’s policy rate hike is likely aimed at adjusting policy to ensure that inflation expectations remain anchored.
Across a broader set of underlying measures, inflation has made progress but remains above the Fed’s 2% target. Trimmed mean and median inflation measures have returned to their pre-pandemic ranges, although readings around 2.5%–3% remain inconsistent with the Fed’s definition of price stability. Notwithstanding looming methodological changes, the median SEP forecast for core PCE inflation in 2026 was marginally higher at 3.4%, and the FOMC no longer appears comfortable with a slow pace of progress from “2-point-something” inflation back to 2.0% inflation.
The Fed is not the only major central bank hiking interest rates in an effort to keep inflation expectations stable, as the European Central Bank hiked its policy rate last week. Given the heightened frequency of asymmetric inflation shocks and geopolitical turmoil, it may be sensible for central banks to lean in a more hawkish direction to ensure their inflation-fighting credibility remains intact.
Labor is not driving U.S. inflation
Nevertheless, this is not 2022. The labor market is one reason the Fed is able to move gradually. Nominal wage growth has decelerated, while higher productivity has helped restrain unit labor costs. Labor’s share of income has also declined, widening the gap between consumer inflation and companies’ labor cost growth. Today’s inflation is therefore more closely associated with profits and non-labor costs than with wages.
Structural forces reinforce that conclusion. Aging and retirements are reducing labor supply, while AI is reshaping hiring, productivity, and worker bargaining power. Worker-flow data also suggest that higher-paid employees are disproportionately leaving full-time employment, pulling aggregate wage growth lower. Wage, unit labor cost, and workforce flow measures consequently show less inflationary pressure than the unemployment rate alone might imply. (Learn more in our 19 August Macro Signposts, “Counterintuitive Labor Market Shifts Constrain Measured U.S. Wage Gains.”)
Aside from rising non-labor costs, inflationary pressures in the U.S. economy are coming from strong corporate profits and wealth gains. This is consistent with the “K-shaped” narrative of the economy (in which gains are felt more by higher-income segments of the population), but historically inflation and unit labor costs tend to move in tandem. With the labor market not exhibiting inflationary pressures and productivity growth remaining robust, underlying inflation may slow as the impact from tariffs and computer memory prices fades.
A changing Fed under Warsh
Finally, the September meeting offered another glimpse of how the Fed is changing under Warsh’s leadership. Warsh’s communication regarding the Fed’s commitment to price stability has been resolute, and as he stated at Jackson Hole, the Fed must be “confident that underlying inflation is moving to [its 2%] objective, clearly and at sufficient speed” or there is “work to do.”
The September meeting was the first time that Warsh’s rhetoric was supported by action, and we believe the Fed is likely to follow with additional tightening as it navigates the final mile of disinflation.
