The stock market was down more than 3% following a stronger than expected inflation report for August which showed prices rising by 8.3% compared to last year which was above expectations of 8.1%. Monthly core CPI also missed badly at a 0.6% gain while expectations were for a 0.1% gain.

All in all, the August inflation data has changed the calculus for the upcoming Federal Open Market Committee (FOMC) meeting. Entering Tuesday, expectations were for either a 50 basis point or 75 basis point hike. Now, probabilities continue to favor a 75 basis point hike, but the second-highest probability is for a 100 basis points hike.

Similarly, there was weakness in Treasuries as rates moved higher in anticipation of a tighter Federal Reserve. The 2-year note gained 25 basis points, and the 10-year rose by 60 basis points and is now nearing its recent high of 3.5%.

The biggest contributors were higher shelter and food costs which were more than enough to offset gains from lower gas prices. One catalyst for a longer period of tight money is that inflation becomes entrenched. This may be happening as core CPI was quite strong with a 0.6% monthly increase and a 6.3% annual jump.

Shelter costs account for about a third of CPI and were up 0.8% for the month. Medical services were up 0.8% as well. New vehicle prices were also up 0.8% on a monthly basis despite a decline in used car prices.

On a bigger level, this CPI certainly dampens hopes of a quick reversal in inflation that could lead to a Fed pivot. And, it increases the odds of tighter and restrictive monetary policy for longer.

This is certainly a bearish development for the market as one of the core tenets of the bullish case was that inflation was going to start trending in the other direction. Another is the resilience of the economy and earnings. However, this cannot be guaranteed with rates at a higher level and restrictive monetary policy for longer.

The Fed has also raised its threshold for what it considers a sufficient reading on inflation actually improving. This means that core CPI probably needs to decelerate on a monthly basis for a couple of quarters before it slows down on rate hikes.

A couple of months ago, many market participants were pricing in Fed rate cuts in 2023. Now, it seems more likely that we could have rates above 4% as we enter 2023.