The Independent Market Observer

Fed Preview: How High Will Rates Go?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jul 26, 2022 11:28:46 AM

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Fed previewSo, what will the Fed do at today's meeting? Almost everyone thinks it will raise rates by 75 bps, or three-quarters of a percent. Almost, in this case, means that a minority of people think the Fed will raise rates by more, like a full percentage point. But the takeaway is that everyone does expect rates to go up—and by an amount that, prior to the past couple of months, would have been shockingly large.

The rate increase itself is fully incorporated into markets. Don’t expect much, if any, reaction from a 75-point decision. If we get a 100-point decision, that might generate some market reaction. But the reaction is as likely to be positive as negative, as markets conclude that the Fed getting preemptive about inflation is a good thing, in the long run.

Short version, the Fed raises rates as expected—and the markets yawn.

Where Things Get Interesting . . .

The follow-up comments can get interesting, as the market tries to parse what they mean for the Fed’s policy decisions through the rest of the year. Current betting is on a couple more hikes of around 50 bps each, with the target rate topping out at around 3.5 percent to 4.0 percent. If that is what the comments suggest, again no real market reaction.

There is an increasing chance the Fed might surprise on the dovish side in its comments. While we will likely see support for continued rate hikes, there are several signals that they might be smaller, and end sooner, than expected.

More Dovish Than Expected?

First is the fact that expectations of a recession are rising. The Fed’s higher rates policy is working, as demand slows down. The housing market, in particular, is slowing sharply, and there are signs other areas of spending are slowing as well. This is something the Fed explicitly wanted to accomplish with higher rates. With the effects so far, the need for even higher rates is starting to erode.

Second, because of the rising recession risk, markets now expect the Fed to raise rates in the short term but then to start cutting them again, likely next year. Longer-term interest rates never went up that much and are now pulling back—a sign that current higher rates are not expected to last. It may well be too early for the Fed to acknowledge that explicitly, but it is not too early for the Fed to put rising signs of weakness on the agenda. If it does, then that will be a signal that rate increases may end sooner than expected.

Third is because the primary reason for the rate hikes, inflation, is showing signs of rolling over. Some of the key inflation drivers (e.g., the price of gas) have declined, and supply chains continue to improve, driving supply up even as demand eases. With inflation at 40-year highs, the Fed has pushed rates up quickly, but there will be much less need to do so once inflation moderates toward the end of the year.

Finally, when we look beyond the next year or so, there are even more signs the Fed’s job is largely done. One of the main drivers of continued inflation is expectations, which can become a self-fulfilling prophecy. While there were signs that public inflation expectations over the next five years had started to rise, multiple surveys are showing they have now pulled back, reducing that risk, which is a key Fed worry. Overall, there are signs that the Fed’s policy has largely done what it intended.

Start of the Endgame?

Mind you, it is still too early to pull back, and the Fed won’t. It will be 75 bps today and guidance to 50 bps at each of the next two meetings. But it is not too early to start to point to what comes after that, which is likely to be less hawkish. Expect more comments on the rising risks of a slowdown and discussion of what changes in policy will be appropriate then.

We are at the start of the endgame on the Fed’s anti-inflation policy. Watch the comments to see just how close the Fed thinks we are.

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