TL;DR

· A former Federal Reserve economist has shifted their policy stance from "maintaining interest rates unchanged" to "raising rates," advocating for an initial 25-basis-point hike in September, with a potential cumulative increase of 50 to 75 basis points by year-end.

· Current inflation data still supports holding rates steady, but disinflation progress remains limited. Core PCE rose 0.2% month-over-month in July, equivalent to an annualized rate of about 3%, still far from the 2% target.

Sahm believes that the slowdown in inflation over the past three months may be influenced by seasonal factors and does not necessarily indicate a significant improvement in underlying inflation trends.

· If the Middle East conflict continues to push up gasoline and diesel prices, cost pressures may gradually spread from energy to transportation and other essential goods and services.

Trade tensions between the United States and Canada suggest that the cycle of tariff increases may not yet be over, potentially putting further pressure on commodity inflation.

Investment in AI infrastructure may temporarily increase prices of key components such as memory chips, and its inflationary impact differs from one-time energy or tariff shocks.

· The rate hike is not a complete reversal of Sahm’s baseline inflation scenario, but rather a risk management move: using modest tightening to hedge against the possibility of inflation remaining above target over the next year.

Editor's Note: The challenge facing the Federal Reserve at its September meeting is not just whether the latest CPI report is hotter or colder than expected.

Although recent inflation data has declined since the beginning of the year, the pace of decline remains slow; meanwhile, the situation in the Middle East, trade tensions between the United States and Canada, and chip demand driven by AI infrastructure investments are creating new price pressures.

Economist and creator of the "Sahm Rule," Claudia Sahm, has therefore changed her previous stance supporting maintaining interest rates unchanged. She argues that, based solely on current data, the Fed still barely has the option to wait; however, monetary policy must address future risks, not just explain already occurred inflation. Sustained high energy prices could transmit to core inflation, new tariffs could disrupt the disinflation of goods, and AI-related capital spending could create more persistent demand pressures.

She still views inflation easing as the baseline scenario and acknowledges that the decision to raise rates or hold steady is nearly a coin flip. However, given her uncertainty that PCE inflation will return to 2% on its own over the next one to two years, she advocates for a small rate hike as a form of "insurance."

The following is the translated text:

Why did I shift from maintaining interest rates unchanged to supporting rate hikes?

Rate hike or hold steady? That’s the question the Fed must answer at its meeting next week. One thing is certain: Fed officials are already divided, and this split is unlikely to be resolved by a single CPI report.

Recently, I changed my preferred policy choice from "maintaining rates unchanged" to "raising rates," because I can no longer be confident that PCE inflation will return to 2% over the next one to two years unless the Federal Reserve raises rates further.

More importantly, upward risks to inflation have increased since July. I believe the Fed could begin with a 25-basis-point rate hike in September and cumulatively raise rates by 50 to 75 basis points before year-end to ensure inflation declines promptly and sustainably.

This does not mean that current inflation data has significantly worsened. On the contrary, recent data has been slightly positive. What has truly tipped the balance toward rate hikes is the prolonged lack of de-escalation in the Middle East, the trade war between the United States and Canada, and chip shortages driven by AI infrastructure development.

Based solely on current inflation data, the Fed could still choose to hold rates steady, but the rationale is no longer as strong.

As of July, both overall and core PCE inflation have declined from their年初 highs, which can be seen as evidence that disinflation is continuing, but the improvement has been limited. The inflation rate over the past 12 months has decreased slowly, and the recently released PPI and CPI will serve as the main inputs for the August PCE data. The market generally expects inflation to slow further, but it remains far from the 2% target.

I remain cautious about the positive signals released by recent three-month inflation trends. Over the past few years, PCE inflation has exhibited certain seasonality: higher at the beginning of the year, then gradually declining. In July, core PCE rose 0.2% month-over-month, equivalent to an annualized rate of about 3%. This pace is lower than in the first half of the year but still significantly above the 2% target.

Therefore, recent data appears to be absorbing the unusual升温 at the beginning of the year and returning to the already elevated pace seen last year, rather than demonstrating a substantive improvement in the underlying inflation trend.

The seasonal pattern of core PCE inflation being higher at the beginning of the year and declining in the middle of the year may lead to an overestimation of the cooling signal from the recent three-month data.

Temporary shocks are becoming more persistent

Given limited disinflation progress and a resilient labor market, why did the Fed previously maintain interest rates unchanged? And why did I continue to support this decision until just a few weeks ago?

The key lies in the type of shock driving inflation.

Last year, tariffs were significantly increased, pushing up product prices. However, once higher import costs are fully reflected in end prices, the incremental impact of tariffs on inflation typically diminishes over time. The same applies to disruptions in Middle Eastern energy supplies: energy prices rise rapidly at first, but may fall back once the conflict ends, thereby helping to reduce inflation.

Such shocks often cause a one-time increase in price levels and do not necessarily lead to sustained inflation. If the Fed responds with interest rate hikes, it may over-suppress demand in an effort to curb price pressures that would naturally subside on their own.

Previous data largely supported this assessment, but the risks going forward have changed.

A simple rise in energy prices alone is not sufficient justification for the Federal Reserve to raise interest rates. However, if energy prices remain high over the long term and gradually transmit to non-energy goods and services, monetary policy may need to respond.

Historical experience shows that after energy prices rise, airfare typically increases rapidly; other core prices respond less and more slowly, with the pass-through effect potentially peaking after a year or longer. A 10% increase in gasoline prices is associated with an approximate 0.2 percentage point rise in core inflation over the following year.

The transmission of rising energy prices to core inflation is slow, with the impact potentially peaking after a year or longer.

This impact may seem limited, but the longer energy prices remain high, the more pronounced the cumulative effect on inflation becomes.

When the Middle East conflict first began, assuming its swift resolution was a reasonable baseline scenario; however, making this assumption is now increasingly difficult. If gasoline prices remain at current levels, their impact on core inflation could persist into next year.

Diesel prices are particularly noteworthy. As a major cost in transportation and logistics, rising diesel prices can impact a wide range of goods and services. The prolonged delay in restoring passage through the Strait of Hormuz means core inflation still faces additional upward risks.

The July Fed meeting minutes showed that most officials believed the impact of tariffs on inflation has largely peaked and will gradually diminish going forward.

This trend is already reflected in the data. After tariffs took effect last year, the three-month annualized increase in core commodity prices rose rapidly, peaked earlier this year, and then declined noticeably over the summer.

After the tariffs were implemented, core goods inflation in the U.S. rose significantly; although it has recently declined, further cooling depends on the assumption that tariffs will not be increased further.

However, for continued disinflation of goods, it is necessary that tariff rates do not increase further.

Currently, the scale of Canadian imports affected by the U.S. additional 50% tariff is relatively limited, but Canada’s retaliatory measures against U.S. goods could prompt the U.S. to further raise tariffs. More importantly, this dispute highlights that the U.S. government continues to use tariffs as a negotiating tool.

Therefore, the risk that tariffs have reignited inflation has increased compared to the previous Federal Reserve meeting.

AI infrastructure construction is another underappreciated source of inflation. NVIDIA’s recent earnings report showed that demand for AI remains strong, with large cloud providers expected to spend over $1 trillion on capital expenditures next year.

Over a five- or ten-year horizon, AI-driven productivity gains may have a deflationary effect. However, within the one-year time frame that monetary policy is currently focused on, AI investment is more likely to exert upward pressure on inflation.

Data on consumer and business investment prices have shown that storage chip prices are rising. Although spending on these items may represent a limited share of the overall economy, it still increases the risk of upward inflation pressure.

Investment in AI infrastructure is driving increased demand for memory chips, with signs of rising prices in related consumer and enterprise investments.

The price pressure brought about by AI construction is fundamentally a demand-driven factor. While the Fed may choose to temporarily ignore energy and tariff shocks, as their impact may fade on its own, the underlying shortage of storage chips stems from sustained investment demand—same logic may not apply here.

Interest rate hikes are an insurance policy against future risks.

Overall, my baseline scenario remains that inflation will continue to decline. However, upward risks to inflation have become substantial and are spread across multiple areas, including energy, commodities, transportation, and technology investments.

From a risk management perspective, the Fed has reason to further tighten monetary policy. While raising rates during a phase of declining inflation may seem contradictory, the policy goal is not only to bring inflation ultimately to 2%, but also to ensure that inflation continues to decline in a sufficiently credible manner over the coming year.

A moderate interest rate hike now is like buying insurance against rising inflation risks.

Of course, there are sound reasons to maintain interest rates unchanged, particularly when policymakers place greater emphasis on existing data rather than forecasts and tail risks. If this week’s inflation data shows significant improvement, or if the aforementioned risks ease, I might also shift back to supporting a hold. Monetary policy judgments inherently require continuous adjustment as new information emerges.

Since 2024, I have been participating in the Shadow Economic Forecast Summary organized by Duke University. In March of this year, I still anticipated that the Federal Reserve would cut rates this year; by June, I shifted to supporting maintaining rates unchanged; now, I believe two rate hikes may be necessary this year, and the path for interest rates over the coming years will be higher.

This does not mean the Fed will definitely raise rates. For those officials who previously believed maintaining the current rate was more appropriate, they would need to change their stance, as I have, to form a majority in favor of a rate hike. This remains a very close decision.

The market needs more than just a decision

The decision at the September meeting whether to raise rates or hold them steady will be a difficult one. Current inflation data still supports the Fed’s wait-and-see approach, but the inflation outlook has deteriorated due to increasing upside risks. Given this, I believe a modest increase in the federal funds rate is more appropriate.

Regardless of the Fed’s final decision, the market needs a clear explanation.

It’s not scary that the outcome is uncertain before the FOMC meeting; what’s truly unacceptable is that after the press conference, the market still doesn’t understand why the Fed made this decision.

If most officials still believe inflation will return to 2% soon, they need to explain where this confidence comes from; if they no longer believe this, then the Fed should act to rebuild credibility that inflation can return to its target.

Click to learn about the open positions at BlockBeats

Welcome to the official BlockBeats community:

Telegram subscription group: https://t.me/theblockbeats

Telegram group: https://t.me/BlockBeats_App

Official Twitter account: https://twitter.com/BlockBeatsAsia