Dissecting the Inflation Report

U.S. consumer prices rose 8.3% in August from a year earlier, above economists’ average forecast of 8.1%. The hotter than expected inflation data is sending stocks lower as traders reassess how high the Federal Reserve will hike interest rates.

The cost of food rose by 11.4% year-on-year, the most since 1979, while shelter costs, which make up about a third of the CPI, increased 6.2%, the most in over 30 years. Housing prices often lag the CPI, meaning that inflation could remain elevated during September.

That could keep the Fed aggressively hiking into the end of the year. Markets are now pricing in at least a 75-basis point at the Fed's September meeting next week with a minor chance of a 100-basis point hike.

With only one more monthly CPI report before the Fed's November 2nd meeting, a 75-basis point hike may also be on the table for that meeting. Fed officials have said they are looking for improvement in the inflation numbers over several months before stepping off the gas.

Before the data release, traders had largely shrugged off generally hawkish comments from Fed officials during September on expectations that inflation was subsiding. The S&P 500 index was up 3.9% on the month as of Monday's close.

With some traders being positioned for an upside move, Tuesday's sell-off could be exacerbated as they exit their positions given the fundamental change in their inflation thesis.