Federal Reserve officials enter this week's policy meeting debating a central question: what the Fed can, should, and will do about inflation that shows no sign of easing soon. When the rate-setting Federal Open Market Committee releases its decision on Wednesday, markets widely expect the benchmark rate to stay unchanged after September's 25 basis point hike. However, investors will closely watch policymakers, especially Chair Kevin Warsh, for clues about future moves. Deutsche Bank senior U.S. economist Brett Ryan said he will look for signals from Warsh about future policy steps — though the Fed chair has said he is very reluctant to do so, as he tries to steer the Fed away from the "forward guidance" approach most central banks adopted for much of the 21st century. Ryan wrote in a note to clients that the chair "may signal that recent inflation data reinforce the September meeting's expectation that further tightening may be needed over time. However, holding steady in October gives officials more time to assess data trends."
Inflation Heats Up
Recent inflation data has done little to ease the price pressures that intensified earlier this year. The widely cited Consumer Price Index showed a 3.7% year-over-year increase in September, driven mainly by surging energy prices. Even excluding volatile gasoline and grocery costs, core CPI still rose 2.6% year-over-year — well above the Fed's 2% target, and up 0.3 percentage points from August, moving in the wrong direction. Meanwhile, recent economic data showed the housing market sinking further under the weight of mortgage rates above 7%. The labor market has entered a low-fire, low-hire pattern: layoffs are near their lowest levels since the late 1960s, yet the unemployed are struggling to find work. Calibrating policy under current conditions has become more complex, because Warsh is pushing the Fed to be more unpredictable, avoiding telegraphing policy direction and preferring markets to glean signals from incoming data on their own. Pausing this month may give the Fed more time to assess the impact of earlier hikes on the economy and financial conditions. However, signaling tighter policy could add more pressure on housing and the labor market. Warsh and his colleagues must show they are prepared to contain inflation while avoiding premature commitments on how high rates will go or how fast they will rise. Fundamentally, the Fed can use interest rates to influence inflation. In assessing current conditions, it will almost certainly refrain from acting. Yet markets and economists disagree on what the Fed should do.
Significant Execution Risk
Evercore ISI head of economics and central bank strategy Krishna Guha said the potential for error is high in this situation. Guha said in a Monday note: "Warsh, while claiming not to like coddling investors, is alert to market risk; he should be able to show a steady hand that calms nerves. But there is significant execution risk." For example, the Fed has not detailed how it views the risks to its dual mandate of low inflation and full employment, nor how it views the speed and extent of monetary policy tightening, posing a major challenge. Despite hot inflation data, the unemployment rate is fairly stable. The Fed also weighs financial conditions when setting policy. The Chicago Fed's financial conditions index shows conditions have tightened slightly since the September hike, driven by factors such as stock market volatility. Recent remarks by key Fed officials such as Vice Chair Philip Jefferson and New York Fed President John Williams suggest rate hikes may come every other meeting. But how far the Fed needs to go remains a mystery. Guha interpreted Warsh's recent speech in Bangkok to the World Bank and International Monetary Fund as consistent with the FOMC's "core view." In practice, that means the Fed "acts at a prudent and orderly baseline pace, once a quarter, without pre-committing to what it will learn along the way, how far it may ultimately need to go, and whether it may need to speed up at some point in the future." He added: "If inflation continues to disappoint and/or growth momentum fails to slow, the Fed will add more hikes."
Uncertain Outlook
According to the CME FedWatch tool, federal funds futures market trading shows about a 10% chance the FOMC hikes this week, but more than an 80% chance of a December hike. Markets see a possibility of another hike in March 2027, and then roughly even odds of a final move before the end of next year. Admittedly, economists debate considerably whether the Fed should tighten policy. For example, Citi economists believe moderating inflation data in coming months will give the Fed reason to hold rates steady and possibly begin cutting next year, though the firm forecasts a December hike this year. Allianz chief economic adviser Mohamed El-Erian said he expects further hikes but believes they would be a mistake, because they would hurt vulnerable sectors such as housing and widen economic disparities. El-Erian said Monday: "My sense is that the market is right in thinking they won't act. Warsh will have to package this decision in fairly hawkish language, because the inflation data are all above expectations. My problem is that this is the wrong policy move right now." He added that the solution to concerns about inflation and higher U.S. Treasury yields should be "fiscal restraint, not monetary tightening." El-Erian said: "But we are going to get monetary tightening, and this will be what I call the 'one minus X' problem. The 'X' is tech; tech won't be affected much. What gets hit will be the rest of the economy: housing, consumer auto loans, consumer loans. Those are the areas that will take the hit."
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