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Fed may surprise markets as economy falters

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Fed may surprise markets as economy falters

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

Elizabeth Franz | Reuters

The Fed is widely expected to raise interest rates by three-quarters of a point on Wednesday, which may surprise markets as it sounds more determined on tightening.

That means the Fed will sound “hawkish” or be in a mode bent on raising rates as much as possible to keep inflation in check. The central bank is expected to announce a rate hike at 2 p.m. ET on Wednesday. Federal Reserve Chairman Jerome Powell then briefed the media at 2:30 p.m. ET.

A 75 basis point, or three-quarter point, rate hike would put the federal funds rate in the 2.25% to 2.5% range. The Fed started raising rates in March, when the federal funds rate ranged from zero to 0.25%.

Investors will seek guidance from Powell on what the Fed can do at its next meeting in September. For a time this month, markets were even bracing for a full-point rate hike, but Fed officials discouraged that view.

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

“Two Handed Economists Talk”

The Fed can provide fresh commentary on the economy, and it may acknowledge that the economy is slowing.

“Jay Powell is going to have a lot of talk from two-handed economists,” said Vincent Reinhart, chief economist at Dreyfus and Mellon. “He’s going to say we’re definitely on the way. Going through a weak inventory and trade cycle.”

Reinhart said that while Powell should acknowledge slowing growth, the chairman is also likely to say there is fundamental support for the economy. The labor market remains strong even as jobless claims begin to rise.

“I think it’s going to be a mixed picture. He’s going to speak before real GDP is probably down by a quarter again,” Reinhardt said.

The Fed’s two-day meeting ended on the eve of Thursday’s release of second-quarter gross domestic product, which some economists expect to contract. That suggests the economy may be heading for a recession — and some believe it will technically be a whole, as it will be the second consecutive negative quarter.

However, Reinhart said the National Bureau of Economic Research uses other criteria to judge a recession and is not expected to announce it just yet.

Even so, some traders are betting that the Fed will eventually lead to a recession by aggressively tightening policy. Powell is expected to strengthen the Fed’s rate hike trajectory, which may sound a little hawkish.

“He can talk about a long cycle into next year,” said Michael Schumacher, director of rates strategy at Wells Fargo. “The market is pricing in an end to the excursion cycle soon. This is not realistic. I think he will sound hawkish. “

Futures markets are actually pricing in a turnaround for the Fed next year. Traders are betting the Fed will start cutting rates next spring after cutting the federal funds rate to 3.4% by the end of the year.

‘Inflation has not fallen’

For now, high inflation may allow the central bank to continue raising interest rates. The consumer price index rose 9.1% in June, the highest consumer inflation rate since November 1981.

“We haven’t seen a sequential decline in core CPI,” Caron said. “For me, if it’s a major threshold for them, they’re going to continue to be aggressive. They can communicate that. It sounds hawkish.”

The core CPI, which excludes energy and food, rose 0.7% from 0.6% in May.

Caron said a hawkish-sounding Fed could cause short-term Treasury yields to rise and sell stocks after the meeting. If longer-dated yields, such as the 10-year U.S. Treasury note, continue to fall on recession fears, the yield curve will invert further.

When yields on shorter maturities, such as the 2-year U.S. Treasury note, are higher than those with longer maturities, the yield curve inverts, which is often seen as a recession warning. The yield on the 2-year Treasury note, which best reflects the Fed’s policy, was about 20 basis points higher than the 10-year Treasury note on Monday.

“The main problem: Inflation isn’t coming down,” Cullen said. “They’re not going to really tell you that, but that’s the problem.” He added that as interest rates rise, the Fed won’t be held back by falling asset prices.

“They can’t say they’ve made progress on inflation. They can’t even say they’ve even been successful for a month in a row,” Cullen said. “They might say the policy rate is helping the slowdown. It’s working with a lag.”

Many voices from the Fed

Diane Swonk, chief economist at KPMG, said Powell’s job will be tougher because of divergent views within the Fed over whether it should increase or decrease rate hikes.

“There will still be debates within the Fed. You suddenly have a lot of voices. This is the first time they are fully staffed and you have more Fed chairs,” she said. “There’s now a debate about whether they’re faster or slower. Given the diversity of views, Powell’s message becomes more complicated.”

Powell may also be more vague than at the last meeting and left his options open in September.

“In the past few meetings, Chairman Powell has hinted (or wrongly hinted at) the expected size of the rate change in subsequent meetings. We don’t expect him to be so explicit,” JPMorgan chief economist Michael Feroli said. Say. “While he will almost certainly indicate that the committee expects to continue to tighten policy, with two jobs reports between now and the September meeting, we don’t think it’s good to throw money at the end of July. Powell is likely to get the job done when asked about the economy. When it comes to the possibility of a recession; we doubt he’ll say it’s a risk, but it’s not a foregone conclusion.”

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