September 4, 2026
If there was any doubt previously, the employment report appears to have given the Fed a green light to raise rates at their next meeting on September 15-16. The 162 thousand increase in payroll employment for August was higher than the consensus forecast which anticipated a moderate 40 thousand gain. Given what we know so far GDP growth is likely to climb by a steamy 3.5% in the third quarter. Meanwhile, corporate earnings are on a roll. And while the stock market feels like it has fallen sharply the reality is that it is only 1.0% below its record high level. On the inflation front the August CPI seems likely to surge by 0.5% or so as the price of West Texas intermediate crude oil has rebounded to $90 per barrel which suggests that the CPI inflation rate is likely to accelerate slightly in that month. If the Fed is unwilling to raise rates against this economic backdrop its credibility as an inflation fighter will be destroyed. The questions in our mind are how far it might go and how quickly it will get there. Our sense is that an increase of 0.5% or so in the funds rate to 4.0-4.25% by yearend should be sufficient.
Payroll employment surprised everybody by increasing 162 thousand in August. In the past three months it has increased on average 71 thousand per month. That compares to essentially no growth in 2025. Despite the angst about AI causing significant job losses, the labor market continues to hum along. While proceeding cautiously, employers are beginning to recognize that they may need to hire a few workers to satisfy the demand for their goods and services.
The Fed believes that everyone who wants a job has one when the unemployment rate is 4.2%. It is currently at 4.1%. The broader measure of unemployment is currently at 7.7%. Full employment for this measure is about 8.0%. Any way one slices it, the labor market is doing just fine.
In any given month if employers need to increase production they can either hire more workers or lengthen the workweek of their existing employees. In August they did both. As noted, employment rose by 162 thousand. The nonfarm workweek rose by 0.1 hour to 34.4 hours. That is the longest workweek since March 2024.
The sizeable increase in employment and the longer workweek led to a 0.3% increase in the aggregate hours index (a measure of production) in August. For the quarter as a whole hours worked appear likely to increase by 1.2%. When combined with a projected 2.3% increase in productivity, third quarter GDP is likely to increase by a steamy 3.5%. The expected growth rate is being led by investment spending related to the AI buildout which is soaring. Consumer spending for the quarter should be moderate as wealthier consumers tap into some of their stock market gains to support spending, while those families that are less well off are being forced to cut spending where they can to make ends meet.
It is clear that the AI investment is boosting productivity and producing stellar growth in corporate earnings. Earnings surged 9.1% in the second quarter which means they have risen an eye-popping 22.8% in the past year.
Given the impressive growth in earnings, perhaps it is not so surprising that the stock market continues to be on a roll. All stock measures feel like the war and tariffs have taken a toll, but the reality is that the S&P 500 is only 1.0% below its record high level. That can be wiped out in a single day.
The resumption of serious fighting in the Mideast has caused oil prices to rebound to $90 per barrel from a recent low of about $70. This runup in energy prices will almost certainly show up in the inflation data for August.
We expect the CPI to increase 0.5% in August which would lift the year-over-year increase to 3.5%. The all important core personal consumption expenditures deflator should rise 0.2% in August which should means the 12-month gain would remain at 3.3% which is far above the Fed’s 2.0% target.
Against this background it seems abundantly obvious to us that the Fed will raise the funds rate by 0.25% in September to 3.75-4.0%. Given Warsh’s oft-stated intent to reduce inflation to 2.0% he and his colleagues need to do something now. If not now when? A 0.25% hike seems like the best bet. But could the Fed surprise everyone and boost the funds rate by 0.5% to 4.0-4.25% at that meeting? Such action would certainly reinforce the message that the Fed is serious about reducing inflation to 2.0%, But we suspect Warsh would not be able to convince enough of his FOMC pals to go along with such a drastic rate change. Instead, we expect a second rate hike in December which would boost the funds rate to 4.0-4,25% by yearend.
But what we are all trying to figure out is how high the funds rate will need to go to produce the desired slowdown in inflation. If the funds rate climbs to 4.0-4.25% by yearend and the core CPI for the year is 2.5% the real funds rate would be 1.6%. Historically, the funds rate typically averages about 1.0% above the inflation rate so a 1.6% real rate should do the trick. But today’s world is unlike any we have seen in the past which makes any forecast of the ending funds rate particularly uncertain. But for what it is worth, we do not think the funds rate needs to go significantly higher to rein in the inflation rate. The Fed may be able to achieve its objective without sending the economy over the edge into recession. AI spending makes that scenario extremely unlikely.
Stephen Slifer
NumberNomics
Charleston, S.C.
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