Fed expected to hike rates by three-quarters of a point again, but its forecast may matter most

It’s not what the Federal Reserve does, but what it says it might do in the future that will be most crucial when the central bank wraps up its two-day meeting on Wednesday.

The Fed is expected to trigger another rate hike of three-quarters of a point, the third in a row. It will also release new quarterly forecasts on inflation, the economy and the future path of interest rates on Wednesday at 2pm ET.

The Fed’s projections are always important, but they are even more so this time as investors have tried to gamble on how much the Fed will raise interest rates and how much officials expect its actions to affect the economy.

Fed Chairman Jerome Powell speaks at 2:30 pm ET, and is expected to emphasize that the Fed will do what it takes to fight inflation and is unlikely to reverse rate hikes anytime soon.

“I think he’s putting a billboard behind him that says ‘inflation has to come down,'” said Rick Rieder, BlackRock’s chief investment officer for global fixed income. “I think he’s going to speak loudly.”

The Fed’s new forecasts also come as the central bank moves into a rate hike zone that some economists expect will be more restrictive and could hit the economy harder.

“It’s not what they do, it’s what they say. This is our first real roadmap for tightening. So far we’ve had theoretical roadmaps, but from the Fed’s point of view they’re going through a world of tightening. That’s an important thing,” said Diane Swonk, chief economist at KPMG.

The Fed has been raising rates for seven months and will now move its target rate above what was considered the neutral zone when inflation was low. The level of interest rates where the Fed’s policy is no longer easy, but still not restrictive, is considered neutral. The Fed has considered 2.5% to be neutral, and if it rises three-quarters of a point, fed funds will be in a range of 3% to 3.25%.

“This is really moving into tight monetary policy territory. We’re going to be moving into no man’s land,” Swonk said. “We haven’t actually tightened policy to fight inflation since the early 1980s. Their goal is a protracted slowdown that slowly reduces inflation and only gradually increases the unemployment rate. Whether they get there is another problem. “.

Rate expectations jumped

Economists have raised their forecasts for how far they expect the Fed to reach the federal funds target before halting rate hikes. This level is called the terminal rate.

Expectations for Fed tightening rose sharply last week, following a surprisingly warm consumer inflation report in August. Fed funds futures were last priced at 4.5% in April on Monday, up from just around 4% ahead of the consumer price index release last Tuesday.

The CPI rose 0.1% in August, while economists had expected a decline.

“The CPI number last week caused a lot in terms of market repricing,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. Stocks have been selling off, and bond yields rose after that report, with some short-term Treasury yields above 4%. The 10-year Treasury yield rose to 3.59% on Tuesday, the highest since April 2011.

The Fed’s last forecast, in June, estimated that the final fed funds rate will be 3.8% in 2023.

Economists now expect the Fed to raise the terminal rate forecast above 4%. Citigroup economists said they could even see a scenario where it could exceed 5% if the Fed needs to be more aggressive in its fight against inflation.

Goldman Sachs economists, in a report, said they expect Fed officials’ median forecast to show the funds rate between 4 percent and 4.25 percent by the end of the year, with another rise to a peak of 4.25% to 4.5% in 2023. Then they expect one cut in 2024 and two more in 2025.

Labor market pain

Swonk expects some of that pain to show a jump in the unemployment rate above 5% by the end of next year.

In June, the Fed predicted the unemployment rate would be 3.7% this year, the same level it was in August. Fed officials also expected unemployment to rise to 3.9% in 2023 and 4.1% in 2024.

“I think they’re going to be a little tight-lipped about the unemployment rate. I’m in the camp that they have to really raise the unemployment rate to really get ahead of inflation,” said Jim Caron, head of Morgan Stanley Investment Management. macro strategies for global fixed income. “They’re in the ‘We shouldn’t do this’ camp.”

Caron said the Fed’s rate hike is a process that will increase the risk of recession.

“By increasing the risks of recession, you reduce the risks of inflation because it is about reducing demand in the economy,” he said. “The sacrifice is slower growth in the future.”

There are some investors betting the Fed will raise rates by a full percentage point, but most economists are predicting a 75 basis point increase. One basis point is equal to 0.01 of a percentage point.

“I think 75 basis points is almost baked in the cake,” Caron said. “Now, it’s going to be about what they’re actually telling us… They don’t want to do forward guidance, but the reality is that people will still look at them as forward guidance.”

‘Out of falcon’ the market

Powell has taken a more hawkish tone this summer. He gave a short, to-the-point speech at the Fed’s annual Jackson Hole symposium in late August, where he warned that the economy could suffer from Fed tightening. The president emphasized that the Fed will use economic data to guide policy. He also stressed that the Fed will keep rates at high levels.

“I think the message will be largely the same as Jackson Hole,” said Michael Gapen, chief U.S. economist at Bank of America. “It will be about achieving a restrictive policy, achieving it over a period of time with the overall goal of price stability.”

Caron said it’s possible Powell could inadvertently appear conciliatory because the Fed has leaned so hawkish.

“I think a 75 basis point move is pretty hawkish, the third in a row,” Caron said. “I don’t think they have to work very hard to ‘beat’ the market.”

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