- Most analysts see the FOMC beginning a tightening cycle at this meeting.
- Fed credibility is on the line.
- Bond market could assist.
The Federal Open Market Committee is expected to raise the fed funds rate target by 25 basis points at this week's meeting, and while some experts say an increase to a rate in the range of 3.75% to 4% is not guaranteed, others speculated what the action would mean.
After last week's
But he doesn't expect aggressive tightening. "Short-term Treasury yields have long signaled that Fed policy needs to move higher, but the gap between the 2-year yield and the fed funds rate suggests the Fed is not dramatically behind the curve," Kourkafas said.
"The upside of a weaker bond market is that short-term yields already reflect expectations of further tightening, meaning they may not need to rise much further even if the Fed moves," he said.
A tightening "could prove supportive of long-term bonds, as it would reinforce the Fed's inflation-fighting credibility and boost confidence that price pressures will ultimately be brought under control," Kourkafas added.
Start of a cycle?
The debate is now not whether the Fed will move this week, but rather how many hikes will be in the cycle, said Seema Shah, chief global strategist at Principal Asset Management.
"We do not expect the Fed to be one-and-done," she said. "This is no longer simply about fine-tuning the economy. After half a decade of above-target inflation, policymakers are likely to conclude that more than one hike will be needed to re-establish price stability."
The midterm elections mean the FOMC will likely hold in October, "making December the most likely opportunity for the Fed to deliver a follow-up hike," Shah said. "Risk assets can comfortably absorb two or three hikes, provided growth and earnings remain strong. But if inflation proves more persistent and the Fed is forced into a more extended tightening cycle, the outlook becomes significantly more challenging."
Jeff Schulze, head investment strategist at Franklin Templeton Institute, said CPI "solidifies the case for several rate hikes in the near-term and will not be a material driver to risk assets."
Luis Alvarado, co-head of global fixed income strategy at Wells Fargo Investment Institute (WFII), said the Fed will likely have to tighten "several" times "to really rein on inflation."
Will the bond market help?
Still, he noted, "the longer the Fed waits, the more the bond market will continue to push yields higher and do the tightening for them."
Yield volatility will continue, Alvarado said, "until investors have confidence that inflation is headed sustainably toward the Fed's target, Treasury yields should remain elevated and the path toward 5% on the 10-year could stays firmly in play."
WFII senior investment strategy analyst Jennifer Timmerman added, building inflation pressures will "force the Fed's hand," with this meeting "being the right moment to start."
Credibility
Credibility could be another reason for the Fed to tighten, said David Kelly, chief global strategist at J.P. Morgan Asset Management. "In the absence of forward guidance, the market groupthink has coalesced around a rate hike this week and if the Fed doesn't deliver one, both Chairman [Kevin] Warsh and the FOMC will lose serious credibility," since the chair has "asserted that the FOMC has no tolerance for persistently elevated inflation."
While markets "project more hawkishness" after rate hikes, Kelly said, with growth and inflation expected "to cool entering 2027," the Fed may hold in October "and raise rates just once more or not at all in December. This should limit any further increase in long-term yields and allow a resumption of a longer-term dollar decline, rewarding investors for continuing to invest in core fixed income for yield, international equities for total return, and alternatives for alpha, income and diversification."
FHN Financial Chief Economist Chris Low agreed, saying recent inflation data "paint a picture of stubborn underlying inflationary pressure," and Warsh's comments suggest "the chairman will guide a willing FOMC to hike rates by a quarter point" at this meeting.
Dot plot
Looking at the dot plot in the last Summary of Economic Projections, Low said, indicates "about half of the FOMC already believed one rate hike would not be sufficient. Given inflation's persistence and the recent direction of fuel prices — which have a way of getting into almost everything — we expect the dot plot will show a strengthened resolve to continue raising rates next year as well."
But the long end of the market will offer a signal, he said. "The 10-year Treasury yield reached 4.84% on Wednesday, its highest since the fall of 2023," Welch said. "If a hike restores credibility, short rates rise while long rates settle. If the 10-year pushes through 5% instead, the market is saying one or two moves will not be enough."
Yield curve
If the Fed raises rates,
Chris Zaccarelli, chief investment officer at Northlight Asset Management, said, while "there's no guarantee that the Fed will hike [at this meeting], but it's hard to see how the central bank can justify leaving rates on hold."
Other thoughts
But some observers don't think a hike is a given.
Alexandra Wilson-Elizondo, global head and co-chief investment officer of multi-asset solutions at Goldman Sachs Asset Management, sees "little evidence to suggest inflation is returning to target in the near-term."
However, she noted, last week's in-line CPI "print keeps the Fed in play without forcing its hand."
Karen Manna, fixed income strategist at Federated Hermes, also pointed to the as-expected CPI as "reinforcing the Fed's current approach" of patience. Inflation, she said, is "moving sideways near current levels," and "does not create urgency for immediate action."
