Fed Chair Kevin Warsh Just Said the Quiet Part Out Loud About Inflation -- and History Says Investors Should Listen

Fed Chair Kevin Warsh used his Aug. 28 keynote speech at Jackson Hole to drive home the point that inflation is broader than the headline rate suggests, speaking directly to the everyday experiences of a rising price level that most people have been having for a while now. Specifically, Warsh said 54% of the 199 items in the personal consumption expenditures (PCE) price index, which is the Fed's preferred inflation gauge, had risen by more than 3% in the 12 months through summer 2026, versus 32% of those items in the two decades before the pandemic.

That's a bit of an awkward situation for the companies that make up the S&P 500 (SNPINDEX: ^GSPC), whose stellar growth in 2026 has been built on profits that are much higher than average. In short, the next thing the market will need to deal with is, in all probability, a Federal Reserve that's keen on making businesses pay more for each dollar of borrowing, which could in turn end up leading to investors paying less for each dollar of profit associated with the assets they buy.

Here's how that could unfold, and soon.

Image source: The White House.

Inflation is running hot, and so is the market

After the Sept. 11 inflation report showed that consumer prices are still rising at a faster-than-desired pace, the odds of a rate hike by the Fed at its meeting on Sept. 16 were 90%, per the CME FedWatch. Warsh also said in his speech that he'd struggle to call the current set of financial conditions restrictive. That obviously means that investors need to brace for higher rates.

Higher rates tend to hit growth stocks hardest. Much of their valuation is based on profits expected years from now, and higher interest rates compress the value of those distant dollars today, while also making it more expensive to borrow the capital that could enable the growth. In 2022, aggressive Fed rate hikes created a brutal, fast bear market. The Nasdaq Composite (NASDAQINDEX: ^IXIC) fell by 33.1% while the Dow Jones Industrial Average (DJINDICES: ^DJI) lost 8.8%.

The complication is that this time around, stocks are starting from a much pricier perch than the fairly rich valuations of 2022. The S&P 500's cyclically adjusted price-to-earnings (CAPE) ratio, which compares stock prices to 10 years of inflation-adjusted profits, was 41 on Sept. 14, a level exceeded only in 1999, 2000, and earlier this summer.

For those who were too young to be investors in 2000, suffice it to say that the crash was one for the history books.

War and oil above $100 could make these hikes hurt even more

Despite the above, small and orderly rate hikes are unlikely to lead to a crash in the market on their own.

But the market isn't just dealing with the specter of new rate hikes; it's also facing down a worsening energy shock first created by and then later also intensified by the Israel-U.S. war with Iran. On Sept. 11, Saudi Arabia shut its East-West oil pipeline. So the flow of oil out of the Middle East is severely compromised relative to its pre-war state, and getting worse.

As a result of that, the price of crude oil is up 64% this year so far, and refined gasoline costs 27.4% more in August 2026 than a year earlier, per the Bureau of Labor Statistics. And if there's one thing that sends inflation into overdrive, it's energy scarcity, as the cost of energy factors into pretty much everything else.

Furthermore, rate hikes can't pump, refine, or transport more oil around the blockades to solve the problem. They can only slow inflation by cooling demand, so each hike squeezes both spending and profits while also shoving the economy toward a possible recession.

The Fed has flinched at similar moments before. When oil prices more than doubled during the 1973-74 embargo, the Fed cut rates despite rising inflation, but it then had to resume rate hikes in March 1974 as the economy contracted faster than expected. Over that period, the S&P 500's CAPE fell from 18.7 in January 1973 to 8.2 in December 1974. A similar contraction now would imply a drawdown on the scale of the year 2000.

In closing, the Fed has repeatedly claimed that it's resolved to fully stamp out inflation, but hiking into an energy shock at near-record valuations is unlikely to be gentle for anyone. If you own richly valued growth stocks whose prices assume years of flawless earnings growth, it's time to think about not buying any more.

Alex Carchidi has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.