It looks increasingly likely that the Federal Reserve will raise interest rates by three-quarters of a percentage point at its meeting this month.
The odds implied by the fed funds futures market of a 75 basis point rise exceeded 80% at one point this morning. They have since gone down to 75% again, which is still overwhelming luck for a great hike. Rather than push back against what the market is implying, Fed officials on Wednesday appeared to encourage the market in that way of thinking.
Cleveland Federal Reserve Chair Loretta Mester said Wednesday she believes the federal funds rate should be above 4% early next year. Other Fed officials, including St. Louis Fed President James Bullard, have said they want to get there by the end of this year. “I don’t really see why you want to extend interest rate hikes into next year,” Bullard said. “I think you might as well do it pretty quickly.”
You can do the math quite easily. The Fed’s current target rate range is 2.25% to 2.50%. There are three meetings this year – in September, November and December – and not another until February 2023. So if the Fed wants to reach its target of around 4% before this February meeting, it will need at least a hike of 75 basis points this year. Given this, it seems likely that Fed officials would start with the biggest hike rather than hold it in reserve for some reason.
Fed Chairman Jerome Powell has shown keen interest in how the market interprets central bank communications and actions. We think there’s a good chance that markets’ surprise with a lower-than-expected rise will be interpreted as a pullback by the Fed in its fight to bring inflation down, and we think Powell understands that. After fending off skeptics of the Fed’s dedication to the anti-inflation cause with his Jackson Hole speech in August, we doubt he wants to spoil this hard-earned victory by weakening now. This is all the more true since there is nothing to be gained by withholding the biggest increase until November or December.
Powell and his fellow Fed official also seem very reluctant to surprise the market. They have been extraordinarily open about their plans, their views on the economy, and the evolution of their thinking on inflation. We therefore doubt that Powell would let the market become as convinced that a 75 basis point hike was coming if he thought there was a good chance the central bank would opt for a smaller hike.
Fed Vice Chair Lael Brainard delivered a speech in New York on Wednesday. Although she did not express a preference on the size of the next increase, her argument for a total fight against inflation is worth considering. Brainard is a former economic adviser to the Clinton administration who spent the Bush administration at the Brookings Institution. She served as Undersecretary for International Affairs in Obama’s Treasury Department before being named Fed Governor by Obama. Biden considered making her treasury secretary, but instead elevated her to vice-chairman of the Fed. She is seen as someone who started out as a centre-left Democrat à la Larry Summers and moved to the left with the rest of her party.
In his speech, Brainard seemed in part to address leftist critics of the Fed’s continued price stability campaign. They argued that central bankers are cavalier about the risks of recession and rising unemployment. Brainard offered a rebuttal to these critics by pointing out that food and energy price inflation is especially hard on the poorest Americans. “While food and energy price increases are weighing on discretionary spending for all Americans, they are especially hard on low-income families, who spend three-quarters of their income on basic necessities. such as food, gasoline and shelter – more than double the 31% for high-income households,” Brainard said.
Brainard, in other words, argues against inflation in order to please the so-called progressive. We think this makes it more likely that the Fed will be able to stick to its guns next year if unemployment rises and leftist criticism reaches a crescendo.