Fed’s 75-or-100 Choice Keeps Traders Guessing as Decision Nears

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(Bloomberg) -- Federal Reserve officials could find reasons for raising rates by a full percentage point next week if they decide to look hard enough, though the base case still looks like 75 basis points.

While most economists see the smaller -- but still aggressive -- hike as the most likely outcome of the central bank’s Sept. 20-21 meeting, a blockbuster move is not a zero risk in the aftermath of a hot reading on August core consumer inflation. Investors ascribe around 24% odds it could happen, according to pricing in interest-rate futures, and some Fed watchers view the probability as higher.

“One percent has to be on the table. They probably will stick to 75 but it’s going to be a close call because you have to think about where they’re starting from,” said Diane Swonk, chief economist at KPMG LLP. 

Following two back-to-back 75-basis-point hikes in June and July, the Fed has already raised rates 225 basis points since it commenced raising rates in March. 

Next week’s increase -- and policy makers from Chair Jerome Powell on down have made it clear that they intend to keep going -- will lift the upper level of their benchmark target rate to either 3.25% or 3.5%, assuming they move by either 75 or 100 basis points. That would put rates into territory where policy will be restraining price pressures.

“They know they have to tighten to derail inflation and they haven’t begun to do that yet,” Swonk said. “They’re playing catch up.”

Ramping up the size of tightening at this month’s meeting would send a powerful message to markets, which have at times in the past few months frustrated officials. Markets rallied following the Fed’s July meeting, taking Powell’s comments in the following press conference as dovish, even though he explicitly left the door open to an “even larger” rate hike if needed.

And inflation’s stubborn persistence, plus strength in other parts of the economy including the labor market, bolster the case for an even more aggressive Fed in the views of some. Nomura Securities, which does forecast a 100 basis-point hike next week, said upside risks to inflation in the August report will push officials to step it up.

Other economists say that while an outsize move is not impossible, ongoing high inflation will instead cause the Fed to keep raising rates for longer, pushing up the terminal rate of this tightening cycle to a higher peak. But it won’t rush to get this done, despite the higher-than-forecast increase in the August core consumer price index.

“Even if CPI doesn’t change the FOMC’s basic approach, it’s still an important incremental change, one that argues for a bit more front-loading and quite possibly a slightly higher terminal rate than otherwise,” Laurence Meyer, a former Fed governor, wrote in a note earlier this week.

The median estimate of Federal Open Market Committee participants in June, when the central bank last published its forecasts, was for rates to peak next year around 3.8%. That will likely move up in the projections updated on Sept. 21, with some seeing it shifting as high as 5%.

“There is little doubt that the inflation data will induce the Fed to be more aggressive over the next several meetings,” Roberto Perli, head of global policy research at Piper Sandler & Co., wrote in a note . “Given that inflation continues to prove itself more persistent than expected and given that most of the FOMC likely agrees with the market that a higher peak rate is called for, it’s not clear that getting there more slowly and gradually is preferable to getting there more quickly.”

While a bigger hike this month would help policy makers get to their terminal rate faster, some economists worry that it might lead markets to expect rate cuts sooner than policy makers intend.  

“Pushing back against expectations of easing next year is not merely a matter of aligning forecasts, but rather of exerting more influence over longer-term interest rates: basically the opposite of the ‘low-for-long’ strategy that many market participants have been raised on,” Michael Feroli, chief US economist at JPMorgan Chase & Co (NYSE:JPM), wrote in a note. “In this regard, a 100 basis point move next week may only encourage those who see easing next year following a Fed accelerating hikes in late ‘22.”

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