Recent inflation data from September came in hotter than expected, and rather than showing clear signs of consumer price inflation peaking, many read it as a sign of just the opposite.

Consumer prices continued to rise faster than expected on a monthly basis, and even members of the Federal Reserve noted in their recent meeting minutes that they have been surprised by the persistence of inflation.

The Fed has acted swiftly to try to put a lid on consumer price increases to no avail. With inflation still high, what will the Fed do next? Let's take a look.

Stubborn inflation

Earlier this year, with inflation coming on faster and stronger than anyone could have imagined in 2021, the Fed seemingly found itself behind the eight-ball and has since moved briskly. 

Federal Reserve building.

Image source: Getty Images.

The Fed did three jumbo 0.75 percentage-point rate hikes at its June, July, and September meetings. After the Consumer Price Index (CPI), which tracks the prices on a market basket of consumer goods and services, posted a jaw-dropping 9.1% year-over-year increase in June, it stayed flat month-over-month in July, prompting a market rally as investors believed inflation could be peaking.

But then the monthly CPI ticked higher in August and has now increased 0.4% in September, the highest monthly increase in three months. The CPI in September was still up 8.2% year over year, as goods and services such as food and rent have remained stubbornly high.

Another jumbo rate hike is coming

This all but ensures the Fed doing another jumbo hike to its benchmark overnight lending rate, the federal funds rate, at its November meeting, which is not too big of a surprise at this point. Fed Chair Jerome Powell has been very clear that the Fed will do whatever is necessary to rein in inflation in order to avoid the kind of runaway inflation seen in the 1970s. 

Currently, most investors believe that a 0.75 percentage-point hike in November, which would increase the federal funds rate to a range between 3.75% and 4%, is all but a lock. It would have taken some very positive data regarding inflation to help the Fed avoid this.

However, a very small percentage of market participants (2.7% of this writing) think the Fed could do a full percentage-point rate hike in November, while more than 97% of market participants expect the 0.75 percentage-point hike, according to CME's FedWatch tool. Investors are also still betting in the futures markets that the Fed will have raised interest rates to close to 5% by next March, implying more rate hikes after the Fed's November meeting.

The Fed is also in the process of shrinking its balance sheet, which is currently in excess of $8 trillion, in a process known as quantitative tightening (QT). During QT, the Fed lets bonds mature and then doesn't reinvest the proceeds, which effectively pulls liquidity out of the economy. In theory, because QT is reducing the money supply, it could help lower inflation, but the actual effects of QT are still largely unknown.

The Fed could increase or decrease its magnitude of QT but has shown no intention to stray from its current plan of reducing its balance sheet by $100 billion per month.

Considerations for the economy

While recent CPI data is not good and while the Fed is poised to do whatever is necessary to avoid a situation like the 1970s, the central bank knows very well that all of these big rate hikes could certainly push the economy into a severe recession

Furthermore, the bulk of the Fed's rate hikes only started in June, meaning they've only had about four months to work their way through the economy -- it typically takes longer. At some point, these rate hikes will cool the economy -- and this is where investors are worried that it will be impossible for the Fed to avoid a severe recession given all of the rate hikes.

All of this points to a 0.75 percentage-point hike in November, but I'll certainly be keeping an eye on the FedWatch tool to see if the probabilities change at all leading up to the Fed's November meeting.