The biggest question hanging over this week's Federal Reserve policy meeting may no longer be whether rates will rise. According to CME FedWatch, after the August CPI print, market pricing for a 25-basis-point hike in September jumped from roughly 70% to nearly 90%, and it has remained above 86% as of this writing.

Goldman Sachs' chief US economist, David Merrick, reversed his stance in a Friday research note, shifting from a "hold steady" forecast to predicting a 25-basis-point hike in September. His reasoning was blunt: "With the market already pricing in nearly 90% probability of a hike, if the Fed chooses to stay put, it could trigger violent market volatility." Earlier hesitants like TD Bank and JPMorgan have also pivoted. KPMG's chief economist, Diane Swonk, summed up the prevailing market consensus in one line: "The question is no longer whether they will hike, but how much they need to hike to contain inflation."

So, what is the remaining 10% probability betting on? It is betting on whether Fed Chair Warsh can find a self-consistent path between "hawkish rhetoric" and "actual action."

The Surface and Substance of Inflation Data

The August CPI report makes it hard to keep telling the story that "inflation is steadily declining." The headline numbers look tolerable—CPI rose 3.4% year-over-year, in line with expectations, and core CPI even fell to 2.4% year-over-year, the lowest since March 2021. But the devil is in the month-over-month figures. Core CPI rose 0.3% month-over-month, above the 0.2% estimate, marking the strongest monthly gain since April. Digging deeper, the details are more unsettling. Shelter costs rose 0.3% month-over-month, communication services surged 2.3%, and airfares jumped 2.7%. Wireless telephone service prices spiked 5.94% in a single month, a record high—Omair Sharif of Inflation Insights calculates that this single item alone contributed 10 basis points to core CPI. Energy prices are no longer the sole driver; the increases are spreading across a broader range of sectors.

According to Stephen Brown, chief North America economist at Capital Economics, based on CPI and PPI data, the Fed's preferred core PCE deflator is likely to rise 0.28% month-over-month in August. That would push the year-over-year core PCE from 3.3% to 3.4%, far above the 2% target. Brown's conclusion is straightforward: "A rate hike is likely to gain broad support within the FOMC."

Adding to the pressure, August PPI rose 5.4% year-over-year earlier in the week, exceeding the 5.3% forecast, while Brent crude surged above $109 per barrel due to Middle East tensions. The upward pressure on inflation can no longer be dismissed with the word "transitory."

Warsh's Credibility Test

This meeting carries unusual weight for Warsh. The new Fed Chair, who took office in May, delivered a notably hawkish debut at Jackson Hole in late August. He stated that despite better-than-expected summer inflation data, "this does not tell me the underlying trend has shown meaningful improvement." If policymakers fail to gain confirmation that inflation is moving back toward the 2% target, "there is still work to do." However, Warsh declined to offer a specific "reaction function" or clarify whether a September hike is needed. "I stand here today committing to a discipline, not a decision." This rhetoric triggered a subtle reaction in the markets.

Sharif of Inflation Insights wrote in a client note: "For the Fed, it's time to put up or shut up." His point is clear—Warsh cannot deliver a speech like Jackson Hole and then fail to support a hike at the subsequent meeting. Economists Anna Wong and Andrew Sacher also argued bluntly that if the Fed does not hike, Warsh's credibility in the eyes of market participants would be completely shattered. This pressure is not unfounded. Warsh's post-meeting press conference in July failed to satisfy investors. JP Coviello, head of portfolio strategy at Citi Wealth, noted: "There is still some concern in the market about the Fed's independence." In other words, this meeting is not just about the rate decision; it is a market pricing of Warsh's personal credibility.

The Bull-Bear Tug-of-War in Equities

Rising rate-hike expectations are clearly weighing on US stocks. The S&P 500 is still up nearly 12% year-to-date, but it has been pulling back recently and is now about 2% below its mid-August record high. The most alarming signal for investors is the bond market—the 10-year Treasury yield briefly touched 4.99%, flirting with the 5% "psychological threshold." Institutions like JPMorgan and Barclays have previously warned that a 10-year yield hitting 5% would make investors significantly more cautious on equity prospects. Cayla Seder, macro multi-asset strategist at State Street, said: "We are in a period of uncertainty. Yields are rising, rate-hike expectations are rising... the market needs to price in overall nervousness."

But not everyone is bearish. A Goldman Sachs research report from September 11 offers a contrarian view: rising rates do not necessarily mean falling stocks—earnings growth is the key to a bull market. Goldman's argument rests on the "earnings yield gap" between the S&P 500's earnings yield (5.2%) and the real 10-year Treasury yield (2.6%), currently at 270 basis points, which has remained fairly stable over the past two years. The relative value of stocks versus bonds has not systematically deteriorated. Goldman also reviewed data from seven rate-hike cycles over the past decades: within three months of a hike, the S&P 500's average return is -2%, with only a 29% probability of positive returns; but within 12 months post-hike, the average return is +9%, with positive returns every time except 2022. The 1997 case is particularly instructive—the Fed hiked by just 25 basis points, the S&P 500 fell 10%, but when the market stopped pricing in further tightening, stocks bottomed out and hit new highs within three months.

The logic chain behind this historical pattern is not complicated: the medium-term impact of rate hikes on stocks ultimately depends on how monetary tightening affects earnings growth. As long as corporate earnings keep growing, valuation compression is limited in its damage. But Goldman also cautions that 75% to 80% of the S&P 500's present value comes from cash flows more than 10 years out, meaning equity valuations are far more sensitive to long-end rates than short-end rates. Interest rate volatility itself is an additional source of risk.

Will a Single Hike Kick Off a New Tightening Cycle?

If a hike does happen, the market's biggest question is another one: Is this a one-off "insurance hike," or the beginning of a longer tightening cycle? "If it signals a cycle—like, we have more work to do—I don't think that's good news for the market," said Alicia Levine, chief investment officer at BNY Wealth, expressing this concern. This divergence is directly reflected in bond market pricing. After the August CPI data, the 2-year Treasury yield rose about 4 basis points, the 10-year was roughly flat, and the 30-year fell 2 basis points, flattening the yield curve. This pattern of "short-end up, long-end down" suggests the bond market leans toward interpreting a hike as "the Fed taking its inflation target seriously" rather than "the start of a new tightening cycle."

The upcoming FOMC statement and Warsh's press conference will be the critical moment to test this judgment. If the statement's wording is hawkish, hinting at further action, the market's first reaction could be a flatter yield curve and pressure on stocks. But if Warsh can convey that "this hike is a disciplined response to inflation data, not a full pivot to tightening," market nervousness might ease. Either way, global markets are experiencing a delicate moment. Seder noted: "If the Fed doesn't hike and the market rallies on that, I think that could be an opportunity to reduce positions. Because there's another possibility—they don't move in September, but they could act at some point later." This sense of unresolved uncertainty may be more unsettling to investors than the hike itself.