The Fed could surprise markets by appearing more aggressive as the economy sways

Federal Reserve Chairman Jerome Powell reacts as he testifies before the Senate Banking, Housing, and Urban Affairs Committee hearing on the “Semi-Annual Monetary Policy Report to Congress,” on Capitol Hill in Washington, DC, US, June 22, 2022.

Elisabeth Frantz | Reuters

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

This means that the Fed will appear “hawkish”, or in a position to be intent on raising interest rates as much as it needs to in order to rein in inflation. The central bank is expected to announce a rate hike on Wednesday at 2 PM ET. Then Fed Chair Jerome Powell briefs the media at 2:30 PM ET.

A 75 basis point hike, or three-quarters of a point, would put the fed funds rate in the 2.25% to 2.5% range. The Fed started raising interest rates in March, when the Fed Funds range was from zero to 0.25%.

Investors will be looking for guidance from Powell on what the Fed can do at its next meeting in September. For a while this month, markets had braced for a full point hike, but Fed officials discouraged that view.

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

“Two-handed Economic Talk”

The Fed could offer fresh comment on the economy, which may admit it is slowing.

“There will be a lot of economic cross-talk from Jay Powell,” said Vincent Reinhart, chief economist at Dreyfus & Mellon. “He’ll say we’re definitely going through a weak stock and trading cycle.”

And while Powell should acknowledge slower growth, the chairman may also say there is fundamental support for the economy, Reinhart said. The labor market remains strong despite rising unemployment claims.

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

The Fed’s two-day meeting concludes on the eve of Thursday’s release of second-quarter GDP, which some economists expect will show contraction. This could indicate that the economy may be heading into a recession – and some believe it will technically be in a recession because it will be a negative second quarter in a row.

However, Reinhart said the National Bureau of Economic Research uses other criteria to judge a recession, and such a recession is not expected to be announced.

However, some traders are betting that the Fed will eventually lead to a recession as it tightens its aggressive policy. Powell is expected to boost the Fed’s rate hike path, and that may sound hawkish.

“He can talk about what cycle will go well next year,” said Michael Schumacher, Wells Fargo’s director of pricing strategy. “The market is quickly putting an end to the hiking cycle. That’s not realistic. I think it’s going to sound too strict.”

The futures market is actually pricing in by the Federal Reserve next year. Traders are betting that the Fed will start cutting rates by next spring, after raising the federal funds rate to 3.4% by the end of this year.

Inflation does not go down

For now, severe inflation is likely to keep the central bank raising interest rates. The Consumer Price Index rose 9.1% in June, the highest rate of consumer inflation since November 1981.

“We haven’t yet seen a sequential core CPI drop,” Karon said. “For me, if that’s the main threshold for them, they’re going to continue to have an aggressive stance. They can communicate that. That might sound tough.”

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

Karon said the seemingly hawkish Fed could cause Treasury yields to rise for shorter periods, and to sell stocks after the meeting. If long-term yields, such as 10-year Treasuries, continue to fall due to recession fears, the yield curve will invert further.

The yield curve inverts when the yield is of a shorter period, such as a two-year Treasury bond rising above the yield of the longer term, and is often seen as a recession warning. The two-year yield, which largely reflects Fed policy, was about 20 basis points more than the 10-year yield on Monday.

“Big problem,” Karon said. “Inflation is not going to go down.” “They won’t really tell you this but that’s the problem.” The Fed will not deter lower asset prices as interest rates rise, he added.

“They can’t say they’re making progress on inflation. They can’t say they’ve even had a straight month of success,” Caron said. “They will probably say that political interest rates help slow the economy. They work with lag.”

Lots of votes in the Federal Reserve

KPMG’s chief economist, Diane Sonk, said Powell’s job will be more challenging given that there are diverse views within the Fed on whether it should raise more or less.

“There is still a debate within the Fed. You suddenly have a lot of votes. This is the first time they are fully staffed, and there are more Fed chairs,” she said. “There is debate about whether it is going faster or slower now. The messages are getting more and more complex for Powell, given the diversity of perspectives.”

Powell may be more ambiguous than he was in the last meeting and leave his options open when it comes to September.

“In the past few meetings, Chairman Powell has indicated (or misrepresented) the expected magnitude of price action in subsequent meetings. We don’t expect him to be very decisive,” said Michael Firoli, chief economist at JPMorgan. “While he would almost certainly indicate that the committee expects policy tightening to continue, with two jobs reports out between now and the September meeting, we don’t see the upside of putting a stake in the ground in late July. It is very likely that Powell will get asked about the chance of a stagnation; we doubt he’d say it’s a risk but it’s not a foregone conclusion.”

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