Fed Mega-Hike Expected On September 21, Despite Tamer Inflation Forecasts

The Fed has been raising rates aggressively to tame inflation since its meetings in March of this year. The last two meetings have seen large 75bps hikes and we could see another when the Fed sets rates on September 21. Futures markets currently give a 9 out of 10 chance that the Fed makes a big 75bps move, with a small chance of 50bps.

These hikes may seem at odds with recent inflation data as most readings and forecasts of inflation have declined significantly in since July. However, the Fed is looking past the swings in energy prices and still worries about underlying trends, such as in food where prices continue to rise.

An Encouraging Inflation Picture

For now, the U.S. inflation picture is somewhat encouraging. Energy, which was a major factor in rising prices has fallen in price over recent months. Given energy can have such large swings in price compared to other goods and services, prices moves for energy can be enough to drive the tone of the overall inflation report as we’re seeing currently.

There are also signals that house prices are starting to decline, and that some of the products, which contributed to the inflation surge, such as used car pricing or elevated freight costs, are now going firmly into reverse driving prices down rather than up. Plus, a very strong dollar is driving down import costs across the board.

The 2% Target

However, here’s the challenge for the Fed. Their target is not to see inflation coming down from its current level of around 8%, but for inflation to be firmly anchored at 2%. Those are quite different goals. The difference between knowing something is falling and knowing precisely where it will land.

We’re a long way from 2% inflation currently, even though prices are falling, and even if inflation were to fall to say 4%, then the Fed would still have a significant problem. That’s why inflation falling is not enough and why the Fed is still on course to hike for now.

The Fed needs to be confident we’ll get back to 2% and excess inflation won’t persist. This was the key point of Powell’s Jackson Hole speech in August 2022.

What Could Change The Feds Plans?

Nonetheless, the market believes the Fed will have more of the data it needs to change emphasis relatively soon. Though uncertainty remains, futures expect, broadly speaking, a 75bps hike in September, a 50bps hike in November and a 25bps hike in December. (Note that there is no scheduled Fed policy meeting in October). So the Fed may start to soften its aggressive approach as 2022 comes to a close.

That suggests that though the data isn’t there yet for the Fed to dial back on rates. Nonetheless, the markets see that data on the horizon, the Fed will, most likely have the data it is hoping for over the coming months. Just not yet.

Jobs Market

A very hot jobs market is also giving the Fed room to raise rates currently. The Fed typically balances managing inflation and growing the economy when setting rates.

For now, the strong jobs market gives the Fed comfort that it has room to raise interest rates. If that changes then the trade-off between controlling inflation and spurring economic growth becomes trickier for Fed policy-makers.

A Cautious Fed

For now, the Fed is being cautious. It worries more about inflation getting out of control or stubbornly remaining after this recent surge, than doing too much to fight it. That’s why the markets see further rate hikes in 2022 even as inflation may start to come down materially. However, by the end of the year the Fed may have the data it needs to be convinced that inflation is back on track to 2%. Hopefully, that’s the case. The worse outcome is that the Fed has to change course because it worries about a U.S. recession, and that’s also a worry.