The Federal Reserve will announce its October interest rate decision at 2 AM Beijing time on Thursday, with markets widely expecting the central bank to keep rates unchanged following a 25 basis point hike at the previous meeting.
Michael Gapen, Chief U.S. Economist at Morgan Stanley, agrees with the market consensus. He stated that the Fed will hold steady in October, but markets should still expect the policy rate to rise in the future. Gapen noted that even if the Fed keeps rates unchanged this month, "the Fed is far from out of the woods."
How will the Fed justify holding rates steady? Gapen believes the Fed will adopt a wait-and-see approach, saying it will observe underlying trends to assess the eventual direction of policy. "So I think the balance right now is that they hold rates steady," but expects the policy rate to move higher down the road.
According to CME FedWatch data, markets assign an 88.9% probability that the Fed will keep rates unchanged this week, up sharply from 35.8% a month ago. Meanwhile, the data shows an 81.6% probability of a rate hike of up to 50 basis points.
Gapen believes the Fed may argue that it will make its own judgment on whether financial conditions have tightened sufficiently before deciding on a policy path. He said: "One argument against hiking at every consecutive meeting is that it could lead to excessive tightening of financial conditions." However, he added that risks exist regardless of which path the Fed takes, but a "more gradual pace" is more likely.
Markets Can Absorb Up to 100 Basis Points of Hikes
The economist also believes that the Middle East war and rising oil prices will pose risks to inflation, adding that Morgan Stanley is "incorporating some of the impact into next year's inflation forecasts," and that the Federal Open Market Committee (FOMC) may also take this into account.
The bigger question is whether the Fed is willing to hike rates at every other meeting and assess based on the latest data. Gapen added that energy markets could determine the direction of policy.
Gapen said: "I think the economy can withstand a total of 75 to 100 basis points of rate hikes without causing significant concerns about yields." But he warned that if the Fed needs to hike a total of six to seven times to return to 2023 levels, that could trigger some concerns.
As of press time, Nasdaq futures and S&P 500 futures were slightly lower, while Dow futures were up 0.16%.
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