AI Strength Meets a More Hawkish Federal Reserve

August 31, 2026

Executive Summary

Markets continue to be supported by strong corporate fundamentals, resilient economic activity, and continued AI-related investment, but the backdrop is becoming more selective as interest rates stay elevated and Federal Reserve policy turns more hawkish. Inflation has improved at the margin but remains above target, leaving the Fed focused on restoring price stability even as corporate profits, business investment, and household income continue to support the expansion. The Iranian conflict and energy agreements with Venezuela continue to add volatility to the energy markets.

Key Takeaways:

• AI remains a key market driver: Nvidia delivered another exceptionally strong quarter, while positive software earnings provided growing evidence that established platforms may be able to monetize AI rather than simply face disruption from it.
• Market leadership narrowed: The NASDAQ Composite and cap-weighted S&P 500 outperformed, while the equal-weighted S&P 500 and small-cap stocks declined, reflecting renewed strength in large-cap technology.
• Economic fundamentals remain supportive: Real GDP growth moderated, but strong corporate profits, business investment, household income, and Gross Domestic Income suggest considerable underlying economic strength.
• Inflation remains above target: July PCE data were broadly in line with expectations and recent inflation readings have improved, but underlying price pressures remain elevated relative to the Federal Reserve’s 2% objective.
• The Federal Reserve struck a more hawkish tone: Chair Kevin Warsh reaffirmed the Fed’s commitment to price stability and emphasized short-term interest rates as its primary policy tool, pushing market-implied odds of a September rate increase to roughly 55%.
• Renewed limited attacks in Iran and Venezuela Oil reserve control sway energy markets: Weekend reciprocal attacks between the U.S. Iran were the first in more than a month. The outline of an agreement for the U.S. to control a large portion of Venezuela’s oil reserves was announced on Friday.

Financial Markets

U.S. equity markets finished modestly higher last week, though performance beneath the surface was notably uneven. The NASDAQ Composite and cap-weighted S&P 500 led the major indices, while the equal-weighted S&P 500 and Small Cap S&P 600 declined.

Artificial intelligence remained a key driver of market sentiment, with Nvidia delivering another exceptionally strong quarter. The company raised its outlook substantially, with fiscal 2028 revenue guidance implying growth of more than 70% and management emphasized that the forecast remains constrained by supply rather than demand. The results helped ease concerns about the durability of AI-related capital spending and supported semiconductor and technology shares. Encouragingly, strength also extended to software, where Salesforce, CrowdStrike, Okta, and Veeva delivered results that challenged the view that AI will primarily disrupt incumbent providers. Instead, recent earnings suggest established platforms may increasingly use AI to enhance products and create new revenue opportunities, reinforcing the importance of distinguishing between companies positioned to monetize AI and those facing disruption from it.

Markets declined on Friday following Federal Reserve Chair Kevin Warsh’s address at the Jackson Hole Economic Symposium. His remarks were interpreted as hawkish, particularly his renewed emphasis on restoring inflation to the Fed’s 2% target. Treasury yields moved higher in response, with the largest increase concentrated at the short end of the yield curve. This “bear steepening” reflected a market reassessment of the likelihood that monetary policy may need to become more restrictive if inflation fails to improve.

While oil prices declined during the week as tanker traffic through the Strait of Hormuz continued to increase, a flare-up in the conflict over the weekend is driving prices higher again. President Trump announced on Friday the outline of a long-term agreement for the U.S. to gain favorable access to Venezuelan oil reserves through a joint project. As the mid-term elections approach, the Administration is highly motivated to show some progress towards lowering gasoline prices which are up 30% since last year.

Economics

Recent economic data continue to indicate an economy growing at a moderate real pace, supported by considerable underlying strength. July’s core Personal Consumption Expenditures (PCE) price index rose 0.2% month over month, in line with expectations, while headline PCE also increased 0.2%. On an annual basis, core inflation remained elevated near 3.3% and headline inflation near 3.7%. Taken alongside broadly in-line CPI and cooler-than-expected producer prices, the data suggest inflation has not meaningfully reaccelerated, though progress toward the Federal Reserve’s 2% target remains incomplete. Household fundamentals were more encouraging, with personal spending rising 0.2% and personal income increasing a stronger 0.4%, suggesting consumers retain the capacity to support growth even as spending moderates and labor market hiring slows.

The second estimate of second-quarter GDP confirmed a 1.5% annualized pace of real growth, but several alternative measures were considerably stronger. Real Gross Domestic Income rose 2.2%, and nominal GDI increased 8.8%. Corporate profitability was particularly notable, with National Income and Product Accounts (NIPA) profits rising 9.1% during the quarter and 22.8% from a year earlier. Business investment also remained firm, as core nondefense capital goods shipments increased 1.4% in July, alongside upward revisions to the prior month. Taken together, strong profitability and continued capital spending provide important cushions for the expansion, supporting investment, hiring, and other business activity, even as headline growth moderates.

Policy

Federal Reserve Chair Kevin Warsh’s Jackson Hole speech was the week’s most consequential policy development. Importantly, Warsh reaffirmed that price stability remains the Fed’s primary focus, described the labor market as broadly stable, and explicitly reiterated both the 2% PCE inflation target and the role of short-term interest rates as the Fed’s principal policy tool. Although he acknowledged recent improvement in inflation and remained constructive on the economy, Warsh said price pressures remain “more concerning,” reinforcing the message that the Fed is not prepared to tolerate inflation persistently above target. Markets interpreted the speech as hawkish, with the policy-sensitive 2-year Treasury yield moving sharply higher and the implied probability of a September rate increase rising to 60%.

Warsh also continued to push back against heavy reliance on forward guidance, warning that frequent Fed commentary can create a “hall of mirrors” in which markets and policymakers react excessively to one another. His preference appears to be for greater emphasis on incoming economic data rather than policy signaling. The speech also reinforced his narrower view of the Federal Reserve’s balance sheet. By emphasizing short-term rates as the primary monetary policy tool, Warsh suggested that balance sheet expansion should be reserved for periods of market dysfunction or crisis, consistent with the Fed’s recent decision to end its Reserve Management Purchase program.

Conclusion

The past week reinforced the balance currently shaping financial markets. Strong corporate fundamentals, highlighted by Nvidia’s exceptional results and growing evidence of AI monetization across software, continue to support equity valuations and investor risk appetite. At the same time, market leadership narrowed as large-cap technology outperformed broader indices. The economic backdrop remains supportive, with corporate profits, business investment, household income, and nominal activity showing considerable strength despite slower real GDP growth. Inflation has also improved at the margin, but underlying price pressures remain above the Federal Reserve’s target, reinforcing Chair Warsh’s Jackson Hole message that the economy remains strong enough to tolerate restrictive policy while the inflation fight is not yet complete.

For investors, the result is a constructive but increasingly selective environment. Continued earnings growth and AI-related investment remain important supports, while improving energy flows through the Strait of Hormuz have reduced a meaningful near-term inflation risk. However, elevated interest rates and the possibility of additional Federal Reserve tightening raise the hurdle for valuations and leave markets more sensitive to disappointment. In this environment, maintaining diversification, emphasizing quality and profitability, and remaining disciplined around valuation remain appropriate as investors balance resilient fundamentals against a Federal Reserve firmly focused on restoring price stability.

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