Last Friday evening, the U.S. released its August CPI data, and the market's reaction was swift. According to the CME's FedWatch tool, the probability of a September rate hike by the Federal Reserve jumped from around 70% to nearly 90% almost instantly.

Yet, the trading session that night was oddly counterintuitive. Instead of falling, gold rallied sharply, leaving many investors puzzled. Several explanations have emerged for this unusual price action.

Some argue that Thursday's higher-than-expected PPI had already priced in some of the bearish news, making Friday's CPI print feel like a "sell the rumor, buy the fact" moment. Others suggest that with the U.S. midterm elections approaching, the Fed's decision-making environment has become more nuanced, and the market may harbor doubts about whether a hike will actually materialize in September, giving gold some room to rebound.

Both interpretations focus on that single night's move. However, looking at just one evening's gains or losses can be skewed by capital flows, sentiment, or technical factors. The more meaningful question is whether the long-held assumption that "rate hikes equal gold declines" truly holds up. Let's take this opportunity to clarify the relationship between rate hikes and gold.

So, how exactly do rate hikes influence gold? To understand this, we first need to clarify what the Fed is actually raising. The Fed adjusts the nominal rate, which roughly equals the real rate plus inflation. It's the real rate that has a genuine negative correlation with gold—the higher the real rate, the weaker gold tends to be.

Why do we often hear that "rate hikes cause gold to fall"? In most cases, hikes are aimed at suppressing demand: as rates rise, borrowing costs increase, cooling consumption and investment, which in turn helps bring inflation down. This dynamic often results in a scenario where nominal rates climb while inflation starts to retreat, squeezing the real rate higher and pressuring gold. That's the logic we're most familiar with.

But this cycle is somewhat different. The current inflationary fire isn't just on the demand side—it's also supply-driven. With tensions in the Middle East pushing oil prices above $100 a barrel, gasoline alone accounted for more than one-third of the August CPI's monthly increase.

This kind of cost-push inflation isn't something rate hikes can easily tame. Even if higher rates curb borrowing and spending, the real costs of oil, transportation, and production are much harder to address. This could lead to a different outcome: on one hand, the Fed hikes, pushing nominal rates up; on the other, supply-side costs keep inflation climbing. If inflation rises faster than the Fed's hikes, the real rate may not increase as much, meaning gold's reaction to rate hikes could be less pronounced than expected. In fact, such second-order inflation expectations could even add more fuel to gold's rally.

Finally, it's worth remembering that when assessing gold today, the focus must ultimately return to inflation itself. A significant part of this inflation stems from the supply side, so applying the old "hike equals gold drop" rule may not be applicable. Going forward, the path will depend on two factors: how the Fed's interest rate trajectory unfolds, and how geopolitical conflicts and energy costs ultimately resolve.