How far will Jerome Powell’s Fed go?


There is no doubt that the Federal Reserve will raise its interest rate target after tomorrow’s meeting of the Federal Open Market Committee (FOMC). What we don’t know is how much they will harvest.

CME Group’s Fedwatch tool tells us that prices for fed funds futures, financial products that allow traders to speculate on Fed policy, currently imply a 75% chance of a 75 basis point rise. base, which is a bit of a scary coincidence. The remaining 25% corresponds to an increase of 100 basis points.

The odds have changed a lot. A week ago, the market was pricing in a nearly 40% chance of a 100 basis point increase. A month ago, the price was zero percent. The reason for this volatility is simple: we are in a period of great uncertainty as to what is happening in the economy. Therefore, it is difficult to predict what policy the Fed will adopt.

It is worth expanding a little further. To correctly predict the Fed’s interest rate decision, it is not enough to know what the data tells us about the economy. You also need to accurately assess how the Fed will interpret this data. The Fed could misinterpret the data – as it did when it said inflation would be transitory – so you need to factor in a possible error. On top of that, you need to gauge what the Fed’s reaction to his interpretation will be.

Traders work on the floor of the New York Stock Exchange on June 15, 2022, as Federal Reserve Chairman Jerome Powell announces an interest rate hike. (TIMOTHY A. CLARY/AFP via Getty Images)

In recent years, the Fed has tried to help the market with this task by explaining how it analyzes economic data and what its bias is at any given time. The Fed is deeply committed to the idea that interest rates, inflation, financial markets and economic activity are controlled to a large extent by expectations. According to this view, inflation expectations produce inflation outcomes; current bond yields reflect the expected path of interest rates; and uncertainty about future conditions causes firms to delay investment decisions. These are expectations until the end.

Yet, on the eve of the FOMC announcement, the market is still divided on what the Fed will do. There is a very good argument that the Fed should tighten by more than 75 basis points. A bigger-than-expected rise would be something of a shock to the market, reinforcing the Fed’s resolve to go further than many currently expect in order to fight inflation. This would be valuable because right now the market is predicting that the Fed will eventually cut rates in the second half of next year or early 2024. This hurts the Fed’s efforts to fight inflation because it implies that economic conditions could change enough that the Fed can be deterred from fighting price volatility until victory.

Moreover, incoming data shows no sign of slowing inflation. Gas prices have fallen, but food prices continue to rise, as Walmart reminded us this week. Prices for some consumer discretionary items, including clothing, could retreat as retailers clear excess inventory, but cars are still in short supply. The housing market is cooling, but house prices are still very high and rising, albeit at a slower pace. On the contrary, inflation appears to be higher than the Fed thought it would be at the June meeting, supporting the idea of ​​a bigger hike.

The Fed, however, probably doesn’t want to surprise the market with a rate hike. This would likely not only trigger a big sell-off in financial markets, but also draw the ire of left-leaning politicians such as Sen. Elizabeth Warren of Massachusetts (D). Warren launched a preemptive strike against a big hike this week in the form of a the wall street journal forum warning against “overzealous rate hikes”. It seems unlikely that the current FOMC will decide to alienate both Wall Street and the Washington left with a 100 basis point hike.

How far will Jerome Powell's Fed go?

Fed Chairman Jerome Powell shakes hands with Senator Elizabeth Warren (D-MA) on November 28, 2017. (Saul Loeb/AFP via Getty Images)

Fed Chairman Jerome Powell’s press conference will be an important opportunity for the central bank to reaffirm its commitment to fighting inflation. To do that, Powell will likely have to downplay the chances of a soft landing and insist that the Fed keep tightening for as long as it takes to get inflation under control, even if it means a recession. If Powell continues to insist that a soft landing is the most likely outcome, he will end up hurting his own credibility.


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