The Fed could surprise markets by seeming even more aggressive as the economy falters

Federal Reserve Chairman Jerome Powell reacts during testimony before a Senate Banking, Housing, and Urban Affairs Committee hearing on the ‘Semi-Annual Report on Monetary Policy to Congress’, on Capitol Hill in Washington, DC , USA, June 22, 2022.

Elizabeth Frantz | Reuters

The Federal Reserve is widely expected to raise interest rates another three-quarters of a point on Wednesday, and it could surprise markets by being even more relentless on policy tightening.

This means the Fed would appear to be “hawkish,” or in a mode where it is determined to raise interest rates as much as it takes to rein in inflation. The central bank is expected to announce the rate hike Wednesday at 2 p.m. ET. Fed Chairman Jerome Powell then briefs the media at 2:30 p.m. ET.

An increase of 75 basis points, or three-quarters of a point, would put the fed funds rate in a range of 2.25% to 2.5%. The Fed began raising interest rates in March, when the fed funds range was zero to 0.25%.

Investors will be waiting for advice from Powell on what the Fed might do at its next meeting in September. For a period this month, the markets had even prepared for a rise of one point, but Fed officials discouraged this view.

“I think they’re going to lean into the warmongering a bit more in September,” said Jim Caron, head of macro strategies for global fixed income at Morgan Stanley Investment Management. “They just don’t see the progress of inflation.”

“Two-Handed Economist Discussion”

The Fed could provide further commentary on the economy, which it can acknowledge is slowing down.

“There’s going to be a lot of two-handed economist talk from Jay Powell,” said Vincent Reinhart, chief economist at Dreyfus and Mellon. “He’s going to say we’re definitely going through a cycle of weak inventory and trade.”

Reinhart said that while Powell was to acknowledge slower growth, the president could also say there is fundamental support for the economy. The labor market is still strong even though unemployment insurance claims have started to increase.

“I think it’s going to be a mixed bag. He’s going to talk ahead of what could be another quarter down in real GDP,” Reinhart said.

The Fed’s two-day meeting ends on the eve of Thursday’s release of second-quarter gross domestic product, which some economists expect to show a contraction. That would suggest the economy could be heading into a recession – and some believe it technically would be, as it would be the second consecutive negative quarter.

However, the National Bureau of Economic Research uses other criteria to judge a recession, and it is not yet expected to declare one, Reinhart said.

Even so, some traders are betting that the Fed will eventually cause a recession with its aggressive policy tightening. Powell should reinforce the Fed’s rate hike path, and that might sound hawkish.

“He could be talking about the cycle that will continue into next year,” said Michael Schumacher, director of pricing strategy at Wells Fargo. “The market is pricing in a pretty quick end to the hiking cycle. It’s just not realistic. I think it’s going to look pretty hawkish.”

The futures market is actually pricing in a U-turn from the Fed next year. Traders are betting that the Fed will start cutting rates by next spring, having raised the federal funds rate to 3.4% by the end of this year.

“Inflation is not falling”

For now, high inflation will likely prompt the central bank to raise rates. The The consumer price index rose 9.1% in Junethe highest consumer inflation since November 1981.

“We haven’t seen sequential core CPI decline yet,” Caron said. “To me, if this is a major threshold for them, they will continue to be aggressive. They could communicate it. It would seem warmongering.”

Core CPI excluding energy and food rose 0.7% in June, from 0.6% in May.

A hawkish-sounding Fed could cause shorter-duration Treasury yields to rise and stocks to sell after the meeting, Caron said. If a longer duration yields, such as the 10 years Treasuries continue to fall on recession fears, the yield curve will invert even further.

The yield curve is inverted when shorter duration yields, such as the 2 years Treasuries are rising above longer-dated yields, and this is often seen as a recession warning. The 2-year, which best reflects Fed policy, was about 20 basis points higher than the 10-year on Monday.

“Major problem: inflation is not going down,” Caron said. “They’re not really going to tell you, but that’s the problem.” He added that the Fed would not be discouraged by falling asset prices as rates rise.

“They can’t say they’re making progress on inflation. They can’t say they even have a straight month of success,” Caron said. “They will probably say that policy interest rates are helping to slow the economy. It works with a lag.”

Many votes at the Fed

Diane Swonk, chief economist at KPMG, said Powell’s job will be more difficult because there are differing opinions within the Fed on whether it should rise more or less.

“There’s still going to be debate within the Fed. You suddenly have a lot of voice. It’s the first time they’ve been fully staffed, and you have more Fed chairs,” he said. she declared. “There’s the debate of whether they’re going faster or slower now. The message becomes more complicated for Powell, given the diversity of viewpoints.”

Powell may also be vaguer than he was at the last meeting and leave his options open when it comes to September.

“At recent meetings, Chairman Powell has signaled (or misreported) the expected magnitude of rate movement at the next meeting. We don’t expect it to be that definitive,” said Michael Feroli, chief economist of JPMorgan. “While it will almost certainly indicate that the committee expects further policy tightening, with two employment reports by the September meeting, we do not see the benefit of putting a stake in the ground at the end of July. Powell will most likely get asked about recession risks; we suspect he will say it’s a risk, but not a foregone conclusion.”

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