Federal Reserve poised for another 75-bp rate hike — question is 'what next'?

Nuthawut Somsuk

The Federal Open Market Committee meets again on Wednesday to decide how much to raise interest rates as the monetary policymakers seek to prove to investors that they’re serious about reining in inflation. Traders, though, are likely to hone in on cues for when the central bank will pause its tightening.

The most recent economic data doesn’t paint a sunny view of inflation. The consumer price index jumped 9.1% in June from a year ago, its fastest rate in more than 40 years, accelerating from 8.6% in May. And the producer price index surged 11.3% in June Y/Y, up from 10.9% in May.

In response, traders started pricing in a 100 basis point rate hike in July, but Fed officials quickly pushed back in their public comments, guiding them back to a 75-bp increase.

Recently, the CME FedWatch tool puts a probability of 75.1% on a 75-bp rate hike to 2.25%-2.5% for the July meeting and a 24.9% probability for a 100-bp increase; for September, markets are pricing in a 49.6% probability for a 50-bp hike on top of that and a 42.0% chance of a 75-bp increase.

Debates over the size of the rate hike miss the point, said RSM Chief U.S. economist Joseph Brusuelas on Friday. “The far more important issue is just how far into restrictive terrain central bankers should lift the policy rate, and at what point they will choose to take the central bank’s foot off the monetary brakes and allow the economy space to further absorb the rate shock the Fed has imposed on the economy to restore price stability,” he wrote in a blog post.

Lifting the rate to 2.25%-2.50% from the current 1.50%-1.75% moves policy restrictive territory, even at the risk of a slower economy, Brusuelas said. RSM sees the Fed continuing to raise rates until it reaches 3.25%-3.5% before it pauses to assess its impact on growth, inflation and employment, Brusuelas said.

“Another three-quarter percentage point rate hike will take the benchmark fed funds rate back to where it was in July 2019, at the peak of the last cycle,” commented Bankrate Chief Financial Analyst Greg McBride. “But with inflation running north of 9%, we’re not a the finish line and there will be more interest rate increases to come in the months ahead.”

Morgan Stanley economists led by Ellen Zenter expect the fed funds rate to peak at 3.625% in December 2022, with the Fed taking the first steps toward normalizing the rate by the end of 2023.

Morgan Stanley Equity Strategist Mike Wilson, though, says equity markets may already be pricing in a pause in the Fed’s rate hikes. In the last four economic cycles, the Fed paused it’s tightening well before the recession arrived, and the period between the pause and the economic downturn was “good for stocks, often VERY good,” the strategists wrote in a note on Monday. “The problem this time is that the pause is likely to come too late,” they said.

Wilson still sees the Fed continuing to raise rates to fight stubbornly high inflation. “The battle on inflation should have begun a year ago, not now when demand destruction is already well developed and likely to take care of inflation on its own,” Wilson said.

J.P. Morgan equity strategists headed by Mislav Matejka, meanwhile, see the growth-policy tradeoff, which worsened from both sides in the first half of 2022, as “likely to improve as we move through 2H.” With challenged activity momentum and softer labor markets “the reset in activity is what many want to see.”

“Crucially, this could open the doors to a more balanced Fed, and is driving a rollover in bond yields, potentially peaking USD and a leveling off in inflation,” Metejka said. This could be a case of “bad data is starting to be seen as good,” he added. The broad pullback in commodity prices “should be interpreted not only as a traditional indicator of softer demand, but also as bringing the relief in inflation pressures.”

The U.S. central bank decision comes after the European Central Bank on Thursday raised rates by a larger-than-expected 50 bps in its first hike in 11 years.

UBS economists led by Jonathan Pingle expect the Fed’s “tough talk” against inflation to continue. But at the same time they estimate that the U.S. economy is in a technical recession — with the GDP decline in Q1 due to noise and the Q2 real GDP as “outright weak.”

“Together, the front-loading of historically outsized rate hikes, combined with a tenuous and vulnerable economic expansion, throws into clear relief the poor trade-offs we think monetary policymakers currently face,” UBS’s Pingle said.

Recall that in June, the FOMC surprised markets by raising its key interest rate by 75 bps, instead of the 50-bp hike it had been indicating before its media blackout period.

Earlier Tuesday, Bill Ackman sees the Fed staying hawkish as the market turns dovish

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