Breitbart Business Digest: How High Will Jerome Powell’s Fed Go?

There’s no doubt that the Federal Reserve is going to raise its interest rate target at the end of tomorrow’s meeting of the Federal Open Market Committee (FOMC). What we do not know is how much they will raise.

The CME Group’s Fedwatch tool tells us that the prices of fed funds futures, financial products that let traders speculate on Fed policy, currently imply a 75 percent chance of a 75-basis point hike, which is a bit of a spooky coincidence. The remaining 25 percent is for a 100-basis point hike.

The odds have shifted around a lot. A week ago, the market was pricing in an almost 40 percent chance of a 100-basis point raise. A month ago, it was pricing in zero percent. The reason for this volatility is simple: We’re in a period of very high uncertainty about what is happening in the economy. As a result, it is hard to predict what policy the Fed will adopt.

This is worth expanding on a bit more. To correctly predict the Fed’s interest rate decision it is not enough to know what the data is telling us about the economy. You also have to accurately gauge how the Fed will interpret that data. The Fed might incorrectly interpret the data—as it did when it said inflation would be transitory—so you have to account for possible error. On top of that, you have to evaluate what the Fed’s reaction to its interpretation will be.

The Fed in recent years has tried mightily to assist the market in this task by explaining how it analyzes economic data and what its bias is at any given time. The Fed has a deep attachment 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 incentivizes companies to delay decisions to invest. It’s expectations all the way down.

Yet here on the eve of the FOMC announcement, the market is still divided on the question of what the Fed will do. There’s a very good argument that the Fed should tighten by more than 75-basis points. A bigger than expected hike would be a sort of shock to the market, cementing the Fed’s willingness to go further than many currently expect in order to fight inflation. This would be valuable because right now the market anticipates the Fed will wind up cutting rates in the second half of next year or in early 2024. This hurts the Fed’s efforts to fight inflation because it implies that economic conditions could shift enough that the Fed can be deterred from battling price instability all the way to victory.

What’s more, the incoming data shows no signs that inflation is waning. Gasoline prices have come down, but food prices are still soaring, as Walmart reminded us this week. Prices of some consumer discretionary items, including apparel, may retreat as retail businesses clear excess inventories, but cars are still in short supply. The housing market is cooling, but prices of homes are still sky high and rising, albeit at a slower path. If anything, inflation appears to be hotter than the Fed thought it would be at the June meeting, which supports the idea of a larger hike.

The Fed, however, probably does not want to surprise the market with a rate hike. This would likely not only trigger a big sell-off in financial markets but also attract the ire of leftist 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 Wall Street Journal op-ed warning against “over-zealous rate hikes.” It seems unlikely that the current FOMC will decide to alienate both Wall Street and leftist Washington with a 100-basis point hike.

Fed Chairman Jerome Powell’s press conference will be an important opportunity for the central bank to reaffirm its commitment to fighting inflation. In order to do so, Powell will likely have to play down the chances of a soft-landing and insist that the Fed will continue to tighten as long as it takes to tame inflation, even if that means a recession. If Powell continues to insist that a soft-landing is the most likely outcome, he will wind up hurting his own credibility.