Markets tested by higher rates and sticky inflation

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

A week of rising oil prices and higher interest rates sent stocks lower across the board as investors increasingly priced in the likelihood that the Federal Reserve (Fed) will begin a rate-hiking cycle at its September 16 meeting. Following the August Consumer Price Index (CPI) report, futures markets implied an 88 percent probability that the Fed will, or at least should, raise rates at next week's meeting.

Ironically, despite apparent divisions within the committee over whether additional tightening is warranted, market pricing itself may leave the Fed little choice. New Fed Chair Kevin Warsh has emphasized that policymakers should be taking cues from market signals rather than the Fed providing markets forward guidance. In some respects, that philosophy may now be boxing the committee into a decision. This is precisely why Warsh has been critical of forward guidance, arguing that it limits policymakers' flexibility. At a minimum, last week's economic data continued to reinforce a theme we have highlighted repeatedly: Inflation remains stuck above the Fed's 2 percent target, a target Warsh has stated the committee is unambiguously and unconditionally committed to achieving.

Despite stocks finishing lower for the week, markets responded somewhat unexpectedly to the CPI report. Equities moved higher on Friday following the slightly hotter than expected inflation reading. Intermediate- and longer-term bonds also steadied, even as markets began pricing in not only a September rate hike but also an additional increase in December and another by April 2027.

The explanation is not entirely clear. Perhaps investors took comfort in oil prices retreating after their sharp rise earlier in the week. Or perhaps they concluded that the rate increases currently being priced into markets will not be significant enough to derail a U.S. economy that continues to demonstrate resilience. After all, the Atlanta Fed's GDPNow model is currently tracking third-quarter growth at 4.41 percent. Combined with last week's surprisingly strong employment report, investors may be concluding that several rate hikes can help reduce inflation without significantly disrupting economic growth.

This is where we continue to urge caution. The U.S. economy remains delicately balanced, and monetary policy remains a blunt instrument. Sticky inflation and rising interest rates remain front and center. Put differently, we do not believe this is simply a story about higher oil prices, nor do we dismiss the risk that additional rate hikes could slow economic activity. The evidence continues to mount that inflation pressures remain persistent. At the same time, higher interest rates increase borrowing costs and can restrict credit availability, both of which matter in an economy where large amounts of capital are needed to bring artificial intelligence (AI) infrastructure to life. A slowdown in AI-related investment would almost certainly weigh on broader economic growth given the sector's outsized contribution to recent activity.

The inflation concerns extend beyond CPI. The prior week's Institute for Supply Management (ISM) Manufacturing and Services reports showed elevated prices-paid components, while broad commodity prices have continued to move higher. This week's National Federation of Independent Business (NFIB) Small Business Optimism Index reinforced those concerns, with small business owners increasingly citing inflation as a problem. At the same time, the share of firms raising prices, as well as the share planning to raise prices, remained well above historical averages.

Consumer inflation expectations are also moving higher. The University of Michigan's September consumer sentiment survey showed one-year inflation expectations increasing to 4.6 percent from 4 percent. More importantly, longer-term inflation expectations over the next five to 10 years edged up to 3.4 percent from 3.3 percent. Add in the findings from the New York Fed survey, which showed both manufacturing and service-sector firms planning future price increases to offset rising costs, and it becomes clear that the risks associated with sticky inflation remain very much alive.

At the same time, inflation is not the only factor pushing rates higher. Rising debt burdens are becoming part of the story as well. Central banks across the developed world continue to raise short-term rates, and intermediate- and longer-term yields have moved higher alongside them.

Last week, the European Central Bank raised rates by 0.25 percent for the second time this year, with markets currently pricing in three additional rate hikes by April 2027. Similarly, the Bank of Japan is widely expected to raise rates by 0.25 percent at this week's meeting, which would also mark its second increase of the year, with markets likewise pricing in three additional hikes by April 2027.

Importantly, higher rates are not limited to the front end of the yield curve, nor to U.S. markets. Longer-term borrowing costs are also moving higher around the globe. The Japanese 10-year government bond yield recently reached its highest level since 1996. Germany's 10-year yield is at its highest level since mid-2009, France's since mid-2008, and Great Britain's since 2007.

Rising rates and the prospect of a broader global tightening cycle carry economic and market risks. One of the most obvious risks remains the growing cost of servicing government debt. We have discussed this issue frequently, and last week's federal budget data offered another reminder. With one month remaining in the fiscal year, net interest outlays have once again surpassed $1 trillion.

The math is straightforward but increasingly important. The average interest rate on outstanding U.S. Treasury debt currently stands at 3.44 percent. Meanwhile, the U.S. Treasury yield curve now ranges from 3.83 percent to 5.31 percent. As a result, each new Treasury issuance comes at a higher borrowing cost than much of the debt it replaces. This dynamic helps explain why the administration would prefer lower rates rather than higher ones, and why it has attempted to reduce longer-term yields through Treasury buybacks. Approximately $6 billion of buybacks were completed on Thursday, but those efforts did little to push yields lower.

These developments highlight the difficult balancing act policymakers face. Inflation remains a problem, but higher rates risk slowing economic growth and further pressuring U.S. consumers, particularly at a time when real income growth remains negative because wage gains continue to lag inflation. At the same time, rising asset prices have helped support consumers through a powerful wealth effect. Federal Reserve data released last week showed household net worth climbed to a record high in the second quarter, driven largely by gains in equity markets. While stronger household balance sheets are constructive for the longer-term outlook, they also create a greater linkage between financial markets and consumer spending. With the stock market now valued at roughly 2.3 times the size of the U.S. economy, any meaningful market pullback could have a larger than normal impact on household confidence and spending behavior.

The housing market offers another example. Rising mortgage rates continue to weigh on activity, creating an additional risk for an economy heavily dependent on consumer spending. Meanwhile, real income expectations, according to the University of Michigan survey, remain near historical lows. AI has undoubtedly been an important driver of recent economic strength, but it is also increasingly sensitive to interest rates. A key question for investors is whether the current pace of AI investment can continue if borrowing costs move meaningfully higher.

Overall, global growth—particularly U.S. growth—remains strong. However, uncertainty about the future is increasing as economies adjust to a world of higher interest rates. Central banks are expected to continue raising shorter-term rates, while intermediate- and longer-term yields are also moving higher.

This is not intended as a dire message. Rather, it is a reminder that higher interest rates have historically acted as a headwind to economic growth. While some investors may read this commentary and conclude that bonds remain risky, we continue to believe that today's higher yields meaningfully improve future return potential. Moreover, if economic growth slows as a result of tighter monetary policy, fixed income may once again provide the diversification benefits and downside protection that investors have historically relied upon during periods of equity market stress.

There also remains an important question about whether central bankers will ultimately follow through on their commitment to fully return inflation to the target given the difficult trade-offs involved. That uncertainty is one reason we continue to advocate portfolios that include exposure to commodities, real estate, and equities that have historically helped cushion the impact of rising prices.

All of this unfolds against the backdrop of growing questions about AI, its ultimate economic impact, and where the value it creates will ultimately accrue. Put simply, we continue to believe that the case for broad diversification is growing stronger. An increasingly uncertain future, marked by shifting inflation dynamics, higher interest rates, and evolving technological change, reinforces the importance of building portfolios capable of navigating a wide range of potential outcomes.

Wall Street wrap

Inflation remains above target despite improving shorter-term trends

August CPI data reinforced the view that inflation remains above the Fed's 2 percent target, even as some underlying measures continue to improve. Headline CPI rose 0.4 percent during the month, leaving the year-over-year rate unchanged at 3.4 percent. Core CPI, which excludes food and energy, increased 0.29 percent during the month, slightly above expectations for a 0.2 percent rise, while the year-over-year rate held steady at 2.4 percent.

Beneath the surface, goods prices rose 0.11 percent during the month and are now up 0.7 percent from a year ago. Services prices increased 0.33 percent and are up 3 percent year over year. Meanwhile, supercore services inflation excluding housing, a measure often watched for signs of persistent underlying inflation pressure, rose 0.51 percent during the month and is up 3.02 percent from a year ago.

Producer prices suggest inflation pressures remain in the pipeline

Producer Price Index (PPI) data also came in somewhat hotter than expected, driven in large part by upward revisions to prior months. The report suggests inflation pressures continue to move through the production pipeline and may not yet be fully reflected in consumer prices.

Final demand prices rose 0.4 percent during the month following a revised 0.1 percent increase in the prior month, which had originally been reported as unchanged. On a year-over-year basis, producer prices accelerated to 5.4 percent, slightly above expectations of 5.3 percent and above the prior month's revised 4.8 percent reading.

Core PPI, which excludes food and energy, rose 0.2 percent during the month, slightly below expectations for a 0.3 percent increase. However, the prior month was revised higher to 0.3 percent from 0.2 percent. On a year-over-year basis, core producer inflation rose to 4.6 percent from 4.3 percent previously.

Small businesses remain optimistic but continue to wrestle with inflation

The NFIB Small Business Optimism Index slipped to 98.7 in August from 99.8 in July, which had marked an 11-month high. Even so, the index remains above its 52-year average.

Labor market indicators continued to point to healthy hiring conditions. The employment index eased to 101.8 from 102.1 but remains above its historical average of 100. Thirty-five percent of firms reported job openings they could not fill, down slightly from 36 percent, while hiring plans fell to 17 percent from 20 percent. Labor quality and availability remained the top concern among owners at 23 percent, though that figure declined four points during the month and remains above the long-term average of 12 percent. At the same time, labor cost concerns fell to their lowest level since March 2021. As NFIB Chief Economist Bill Dunkelberg noted, "Pressure to offer competitive wages is still high, but it's no longer a top challenge for most Main Street employers."

Inflation pressures, however, remain evident. A net 31 percent of firms reported raising selling prices, unchanged from July but still well above the historical average of 14 percent. Likewise, a net 28 percent plan to raise prices over the next three months, unchanged from July and above the long-term average of 22 percent. The share of owners citing inflation as their most important problem rose to 16 percent from 14 percent and is now tied with taxes as the second-largest concern. Historically, that figure has averaged just 7 percent.

Business owners also became somewhat less optimistic about future conditions. Expectations for business conditions fell to 10 percent from 15 percent, while a net 9 percent reported higher sales over the past three months, the weakest reading since November 2025. Expected sales softened to 6 percent from 7 percent, and net earnings slipped to negative 19 percent from negative 17 percent.

Credit conditions improved modestly. The net percentage of owners expecting easier credit conditions rose to negative 2 percent, the highest level since December 2024. Meanwhile, just 4 percent reported paying a higher interest rate on their most recent loan, unchanged from July, while the average interest rate paid on short-maturity loans fell to 7.5 percent from 7.9 percent.

The broader message from the report highlighted an increasingly divided economy. According to NFIB, consumer sentiment remains weak, and retail sales continue to reflect that caution. While beneficiaries of the artificial intelligence (AI) boom and rising equity markets continue to spend, many consumers and small business owners appear left out of those gains.

Consumer sentiment falls to one of the weakest readings on record

The preliminary University of Michigan Consumer Sentiment Survey for September painted an increasingly cautious picture of household attitudes.

Overall sentiment fell to 47.8 from a revised 51.7, marking the second-lowest reading in the survey's history dating back to 1978 and only slightly above May's reading of 44.8. Current conditions slipped to 50.9 from 51.9, while expectations plunged to 45.8 from 51.5.

The report noted that expectations for both personal finances and business conditions deteriorated sharply. Consumers cited higher fuel prices and ongoing trade tensions as reasons for anticipating greater pressure on household budgets in the months ahead.

Inflation expectations also moved higher. One-year inflation expectations rose to 4.6 percent from 4 percent, while longer-term expectations over the next five to 10 years increased to 3.4 percent from 3.3 percent. Expected changes in business conditions over the next year fell to 45 from 58, establishing a new low in data dating back to 1978.

Real household income expectations remain particularly weak. The measure declined to 41 from 42 and sits just above the all-time low reading of 39 recorded in May.

Despite the broader pessimism, consumers remain surprisingly optimistic about the stock market. A total of 60.4 percent of respondents expect stock prices to be higher a year from now, only slightly below last month's 60.6 percent reading and still near the elevated levels reached in late 2024.

For the first time since 2023, a majority of consumers expect interest rates to move higher over the next year, indicating that many households anticipate additional Fed tightening in an effort to bring inflation under control.

Also notable was the broad deterioration in economic views across political affiliations. Even Republicans, who generally viewed economic policy favorably under the current administration, became more pessimistic. As recently as March of this year, 62 percent of Republicans believed the government was doing a good job managing the economy. That figure has now fallen to 35 percent, the lowest reading of the current administration and below nearly all readings recorded during the first Trump administration.

Higher mortgage rates continue to weigh on housing activity

Existing home sales continued to struggle under the weight of elevated home prices and higher mortgage rates. Sales fell to an annualized pace of 3.98 million units in August. For perspective, existing home sales stood at 6.43 million units in January 2022. The latest reading marks the lowest level since June 2025 and sits just above the recent low of 3.86 million reached in December 2023.

The median existing home price rose to $429,100, up 1.6 percent from a year ago. One positive development was an increase in available housing inventory. Homes listed for sale climbed to 1.62 million, the highest level since November 2019. At the same time, housing affordability improved modestly, with the affordability index rising 3.5 percent.

The reality, however, is that affordability remains historically depressed and continues to represent a significant challenge for prospective buyers. Meanwhile, mortgage financing costs remain elevated. According to the Mortgage Bankers Association, the average 30-year fixed mortgage rate rose to 6.85 percent during the week ending September 4, up from the recent low of 6.09 percent reached on February 20, 2026.

The week ahead

Monday: Markets will begin the week looking ahead to the September policy decision of the Federal Open Market Committee (FOMC), with no major scheduled economic releases on the calendar. Investor attention is likely to remain focused on the implications of last week's inflation data and whether recent economic reports have altered expectations for the path of monetary policy.

Tuesday: The Federal Reserve Bank of New York will release its September Empire State Manufacturing Survey at 8:30 a.m. ET, providing an early read on manufacturing activity. We will be watching whether business conditions, new orders, and price measures continue to point to resilience in the factory sector or renewed pressure from tariffs and elevated input costs.

Wednesday: The Census Bureau will release August Retail Sales data at 8:30 a.m. ET, offering an important look at the health of the U.S. consumer. We will be focused on whether spending continues to hold up despite slowing income growth and a declining savings rate. The government will also release August Import and Export Price data and July Business Inventories, which could provide additional insight into inflation pressures and inventory trends across the economy.

Later in the day, at 2:00 p.m. ET, the FOMC will announce its latest interest-rate decision following the September 15–16 meeting. Markets will be closely focused on the policy statement and any signals about the outlook for inflation, growth, and future rate decisions.

Thursday: The Department of Labor will release its weekly Initial Jobless Claims report at 8:30 a.m. ET. We will be monitoring whether claims remain consistent with a labor market that is gradually cooling or begin to signal a more meaningful slowdown in employment conditions.

Also at 8:30 a.m. ET, the government will release August Housing Starts and Building Permits, while the Philadelphia Federal Reserve will publish its September Manufacturing Index. These reports should provide additional insight into both housing activity and business sentiment.

Finally, at 10:00 a.m. ET, the National Association of Realtors will release August Pending Home Sales data, offering another look at housing demand.

Friday: The Federal Reserve will release August Industrial Production and Capacity Utilization data at 9:15 a.m. ET. We will be assessing the market implications of Wednesday's Fed decision and whether policymakers' outlook aligns with expectations for economic growth, inflation, and interest rates heading into the final months of the year.

Frequently Asked Questions

Why are investors focused on interest rates?

Interest rates affect borrowing costs for consumers, businesses, and governments. When rates move higher, they can slow economic activity, pressure areas such as housing, and make it more expensive to fund large investments, including artificial intelligence infrastructure.

Why does inflation still matter for the Federal Reserve?

Inflation remains above the Federal Reserve’s 2 percent target, and recent readings have not shown enough improvement to declare the problem solved. That keeps the Fed focused on price stability and raises the risk that rates may need to stay high or potentially move higher if inflation remains sticky.

How does artificial intelligence factor into the outlook?

Artificial intelligence is helping support growth and may create meaningful productivity gains over time. However, the article notes that it remains unclear where the benefits will ultimately accrue, and the current AI buildout may also be more sensitive to higher interest rates because of its need for capital.

Why does diversification matter in this environment?

A diversified portfolio can help investors prepare for a wider range of possible outcomes. The commentary highlights the potential value of combining fixed income with exposure to commodities, real estate, and equities that have historically helped cushion the impact of rising prices.

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