Urging against another Fed rate hike

   by Scott Martindale
  CEO, Sabrient Systems LLC
 

Quick note: Sabrient’s Q4 2026 Baker’s Dozen just launched on 10/20 as a 15-month portfolio with a diverse mix of 13 concentrated stock picks across market caps and 7 business sectors. The Q3 2025 Baker’s Dozen just terminated on 10/20 with an official 15-month gross total return of +33% vs. +24% for SPY. Its top performer was Valero Energy (VLO) at +197%.

Commentary:

This is a brief update to my 10/6 post, taking into account the latest CPI and PPI inflation readings ahead of next week’s FOMC meeting and rate decision. September inflation metrics came in a bit hot, as expected, suggesting that inflationary pressures reaccelerated during the month. Of course, it was driven primarily by surging energy prices. There was a slight uptick in core inflation as well, but it comes with important caveats that I will discuss. Overall, I continue to strongly urge against rate hikes, as many small businesses, hopeful first-time homebuyers, and lower-income and working-class families continue to struggle under the weight of elevated interest rates.

In fact, I continue to believe the Fed would be better advised to cut its policy rate, which would allow a broader swath of the economy to participate in and contribute to a more robust and broad-based economy. I also opined in my 10/6 post that bonds were likely seeing a “blowoff top” and nearing a cycle peak. Today’s market action seems to finally show some agreement with me, with a huge bid for bonds sending the 10-year yield crashing to well below 5% for the first time since 9/22 in its biggest one-day drop in over two years, and the 30-year mortgage rate turning lower this week for the first time since late August.

The inflation conundrum:

Headline CPI rose 0.6% MoM and 3.72% YoY, up from August’s 0.4% MoM and 3.35% YoY. Gasoline prices jumped by 9.1% MoM, accounting for over half the monthly increase, and a staggering 34.2% YoY, while the broader energy index surged 5.2% MoM and 20.4% YoY. Airfares were up 22.4% YoY. At least food prices were unchanged MoM. But the more troubling report came from producer prices. Headline PPI surged 1.3% MoM and 6.35% YoY, its largest monthly increase since March 2022 and highest annual reading since December 2022. Producer goods prices jumped 2.6%, led by a 10.8% surge in energy prices, including a 20.3% spike in gasoline. Services prices also increased 0.8%, reflecting higher transportation costs and wholesale margins. Importantly, Core PPI (excluding food, energy, and trade services) rose 0.5% MoM and 5.0% YoY. However, as illustrated in the chart below, PPI is more volatile than the consumer metrics, so perhaps hope is not lost. Read on…

There is better news in September Core CPI (excluding volatile food & energy). It rose a more moderate 0.3% MoM and 2.57% YoY, compared with 0.3% MoM and 2.45% YoY in August, so it was just a little hotter. Overall, although the energy shock explains much of the headline acceleration, the uptick in Core CPI suggests underlying price pressures have not entirely subsided. However, if you also exclude shelter costs from Core CPI, the YoY reading falls to just 2.0%.

According to Yahoo Finance, “Only about 38% of the roughly 175 categories in CPI rose faster than a 3% annual pace over the past six months… [which is] down from 56% in May and the fewest since spring 2025.” For example, although shelter inflation edged up 0.4% MoM and 3.2% YoY, which added 0.15 pps to Core CPI, the better news is that the shelter component was primarily driven by hotel prices (“lodging away from home”), which saw a 2.0% MoM jump (following August’s 2.4% MoM increase). So, the surge in hotel and travel pricing masked the underlying cooling trend in residential leases and other shelter metrics.

Moreover, although Core CPI technically excludes food and energy, it is not insulated from energy prices. Oil, natural gas, and petrochemicals are essential inputs throughout the supply chain—not just as fuels but as feedstocks for plastics, synthetic fibers, rubber, chemicals, and pharmaceuticals. Rising fuel costs work their way into freight charges, airfares, and consumer goods, as well as vehicle maintenance, public transportation, new cars, apparel, housing, household supplies, and electricity. And although direct electricity costs are excluded from Core CPI, there is an indirect cost embedded into consumer goods and services prices and tenant rent from rising commercial, industrial, and landlord electricity expenses that are gradually passed through.

Economist and fund manager Daniel Lacalle discussed this impact on various CPI components not considered “energy” and thus not excluded in the Core CPI figure. He opined, “US CPI shows the stupidity of rate hikes. The entire impact comes from refined products. Rate hikes will not create more barrels nor increase refining, but they damage families and businesses.” Alas, there is no escaping the ubiquity of hydrocarbon-based products, components, and ingredients as a necessity in the modern economy. In other words, a sustained energy-price shock like we’ve endured eventually infiltrates “core” inflation, even as investors and the Fed rely upon that measure as a gauge of underlying inflation that technically excludes volatile food and energy costs. This will gradually subside once hostilities end, regardless of Fed policy.

Until 10/29 when the September PCE report is released, we still only have the August report for PCE, as displayed in the earlier chart. But notably, Fed chairman Kevin Warsh’s preferred metric of “Trimmed Mean PCE” came in at 2.19%, down from 2.28% in July. It has been quite stable between 2.2–2.4% all year long, while headline PCE has jumped around 2.9–4.1%. The Dallas Fed calculates Trimmed Mean PCE by “trimming out” a certain fraction of the most extreme observations at both ends of the spectrum (high and low, which can distort the total) and then computing a weighted average of the remaining components to offer a more stable and relevant perspective. It has been shown to outperform the reported Core PCE (ex-food & energy) measure as a gauge of actual core inflation.

Note that Core PCE has a lower weighting to falling shelter costs (17% vs. 44% for Core CPI), a larger weighting to rising healthcare costs (20% vs. 10%), including healthcare services paid by employers, Medicare, Medicaid, and private insurers, and it considers some business-related producer price data that might be passed through—so it’s arguably less representative of the prices consumers see directly.

So, although the Fed historically prefers Core PCE, I think today’s trends in Core CPI are more reflective of prices not impacted by the temporary energy/supply shocks. Historically, Core CPI has always exceeded Core PCE, but that flipped in November 2025. Since then, Core CPI has lagged Core CPI, with the principal drivers for Core PCE being financial services (fees on percentage of assets in a rising market), insurance, and healthcare (largely government regulated)—and notably not housing. This supports my concerns about PCE’s greater exposure to expenditures that are less directly visible to the average household and less impacted by Fed policy.

I also like to follow the real-time, blockchain-based “Truflation” CPI metric, which is updated daily based on 30 million dynamic consumer data points. It is better at reflecting current housing costs than CPI or PCE (which use surveys as well as lagged and imputed data). Truflation CPI shows 3.03% today (10/22), but Truflation Core CPI is just 1.88%.

Looking ahead to the October inflation metrics, the Cleveland Fed’s Inflation Nowcasting model predicts CPI of 3.75%, Core CPI of 2.48%, PCE of 3.72%, and Core PCE of 3.13%. And the 5-year breakeven inflation rate, which reflects the implied forward expectations of investors in 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities, is currently 2.40%.

What should the FOMC take from this?

Overall, if you set aside the event-driven energy and supply-shock impacts upon which Fed policy has little impact (short of inducing a recession), I don’t think underlying inflationary pressures have changed much. Meanwhile, real wage growth has slowed—and actually has gone negative. I continue to believe that both the broad investor consensus and the Fed are misreading the true path of inflation. While headline CPI, PCE, and PPI look alarming at first glance due to those energy/supply shocks, the underlying data tells me a different story—which is best captured by Core CPI, Trimmed Mean PCE, 5-year breakeven inflation, and Truflation Core CPI, which all put underlying inflation much closer to the Fed’s 2.0% target.

Meanwhile, corporate earnings reports are exposing a worrying K-shaped economy. Cash-rich tech hyperscalers are investing aggressively in AI infrastructure, while high-income consumers, cash-flush retiring Baby Boomers, and asset owners in general are spending just fine. Together, this non-rate-sensitive upper leg of the K is driving economic growth and a rising stock market. This tells me that the Fed’s latest rate hike and generally tighter monetary policy is counterproductive given that it has little impact on the upper leg of the K while severely impacting the highly rate-sensitive lower leg of the K—including 9 of the 11 business sectors, small businesses, and lower-income and working-class consumers who don’t own much if any assets.

It gets worse. As economist and global liquidity expert Michael Howell of CrossBorder Capital pointed out, “Investors usually treat a higher Fed funds rate as synonymous with tighter policy. Yet in a debt-saturated economy, higher rates also raise Treasury interest payments to the private sector. These larger income transfers to households, businesses and financial institutions partly offset the intended contractionary effect.” In other words, higher rates not only don’t slow down the upper leg of the K but may actually further benefit it with more interest income—driving even more spending—while further hurting the lower leg. Talk about a kick in the teeth.

So, rate hikes not only don’t help with today’s main inflation drivers but they increase adjustable or revolving borrowing costs for debt-laden consumers—a double whammy. In this environment, the only way I can see rate hikes reducing inflation is by pushing us into recession, and that would be even worse for consumers. It would slow business activity, reduce capex, increase layoffs and unemployment, and slash consumer spending—potentially resulting in negative GDP growth, which means lower tax receipts, higher federal interest expense, and a widening budget deficit, i.e., a disaster.

The chart below from Bianco Research illustrates the K in another way: the S&P 500 Index cumulative price versus the University of Michigan Consumer Sentiment Index. Their point is that the two metrics used to be positively correlated, but since the pandemic lockdowns they have become negatively correlated. Jim Bianco points out that since the pandemic lockdowns (when inflation really took off), cumulative CPI is up 30.5% while average hourly earnings are up 25.7% (as of August). And even though the inflation rate has come down substantially since the pandemic, it has continued to rise to the point that households are finally feeling the cumulative impact on affordability—not to mention the stark realization (as stocks continue to make all-time highs) that they have not benefited from the “good” type of inflation, i.e., asset inflation. Thus, we hear the loudening drumbeat of “tax the rich” and collectivism (“free stuff”).

According to Brian Wesbury, chief economist at First Trust, “AI accounts for 75%+ of economic growth, which means the rest of the economy in total is growing at less than 1% annualized. Housing and autos are still not sustainably above the levels of 2017-19.” And according to Jim Bianco, 41 AI-related companies within the S&P 500 account for nearly 50% of the index’s combined market cap. Furthermore, a similar Bloomberg US AI Enablers and Adopters Index is up about 1,600% over the past 10 years while the rest of the S&P 500 is up about 135%. This is yet another way of illustrating the K-shaped economy.

Not surprisingly, the University of Michigan Consumer Sentiment Index fell from 48.1 in September to 46.3 in October, which is barely above its all-time low reading from May of 44.8. Total consumer spending makes up about 68% of US GDP, but only about 20% or so is truly cyclical, comprising mostly durable goods (e.g., cars and appliances that are typically financed), recreational services, travel, and dining out.

And the cumulative financial pressure on the average consumer may persist even after inflation stabilizes. Household debt now exceeds $18 trillion, savings rates remain below their long-term average, and wage growth has slowed, leaving consumers less able to absorb unexpected costs without borrowing or cutting other spending. The Fed’s latest Beige Book showed that consumer-facing firms reported tighter margins.

While Reuters’ Breakingviews suggested that the $1.7 trillion auto loan market is headed for a crash (as cars are breaking down before their long-duration loans are paid off), and 60-days-past-due, long-duration, subprime loans are at historical highs (6%). And according to economist Danielle DiMartino Booth of QI Research, small business bankruptcies are up 63% year over year, larger corporate bankruptcies are running at a 15-year high, and CCC spreads widened to 1,000 basis points.

On the other hand, the household Debt Service Ratio (DSR), which measures the share of disposable income obligated to mandatory debt payments (mortgages and consumer debt) has essentially flatlined for the past three years at about 11.11% (comprising 5.83% for mortgages plus 5.28% for auto and student loans, credit cards, and LOCs), as of Q2. But that’s a long lag, so I’ll interested to see if the DSR ticks up when the Q3 metric is released in late December.

So, investors should be on the lookout for signs of reduced buying in rate-sensitive, durable items like homes, cars, appliances, and hot tubs, which could put a dent in the robust, AI-driven, 30% EPS growth projected for the S&P 500 and 41% for the Nasdaq 100 in Q3. Analysts have been cutting earnings estimates for Consumer Discretionary and Consumer Staples sectors on concerns that rising borrowing will soon hit a wall and slow the resilient household spending. This is why Sabrient’s latest SectorCast rankings of business sectors score those two consumer sectors at the bottom. Indeed, we have seen reports from Nike, Lululemon, PepsiCo, Lowe’s, Delta Air Lines, and many others revealing troubles brewing for margins and profits.

More rate hikes are not the answer:

Again, I continue to strongly urge against further Fed rate hikes. Many small businesses, hopeful first-time homebuyers, and lower-income and working-class families continue to struggle with the current level of interest rates. So, although many FOMC members are pushing for at least one additional rate hike this year, I continue to believe the Fed would be better advised to cut its policy rate, ultimately to a 3.0-3.25% neutral rate, which would allow a larger swath of the economy to participate in and contribute to a more robust and broad-based economy, as well as provide relief to borrowers in emerging markets suffering under a strong dollar.

The hyper-financialized global economy means that rising rates could cripple debt-addicted businesses, governments (including our own federal government), and the housing market (which is critical for a healthy consumer). Sure, 30-year mortgage rates (reaching as high as 7.4% this month) have been much higher in the past, but home prices today are based on a lower baseline of post-GFC easing and low rates. And given recent strengthening of the dollar, some emerging market economies with dollar-denominated debt may be forced into default. In other words, today’s global financial system simply can’t handle higher US interest rates.

According to Michael Howell, global liquidity levels have been declining over the past couple of weeks due to weak collateral values (declining bond prices) and a strong US dollar. In Howell’s framework, the financial system is a collateral-driven, debt-refinancing mechanism. Safe, high-grade government bonds (mainly US Treasuries) serve as the primary collateral that dealers, banks, and shadow banks pledge to borrow cash and create credit on margin (leverage). So, falling bond prices and rising bond market volatility serve to shrink the collateral multiplier, which reduces global liquidity.

Once the energy/supply shock finally ends, I remain quite clear in my view of the overriding weight of the many powerful, secular, disinflationary trends versus short-term, event-driven, or one-time price spikes we have seen with the pandemic lockdowns and now the Iran war. Those trends include aging demographics, slowing global population growth, accelerating disruptive innovation like AI and automation, rising productivity, falling shelter costs, modest liquidity growth, a strong/stable dollar, the redundancy (and “duplicative excess capacity”) of America’s factory reshoring and re-industrialization, and the deflationary impulse on the world from a struggling mercantilist China. Because so many Chinese companies are unprofitable, servicing their huge debts mean “dumping” goods—ranging from cars to electronics to solar panels—on a world that is already struggling to achieve economic growth.

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