If September's rate hike fails to noticeably curb inflation, the Federal Reserve may consider a single 50 basis point increase in December, rather than the usual 25 basis points expected by the market.
The Fed is widely expected to pause this week, but persistently elevated inflation, still-resilient economic activity, and relatively loose financial conditions are casting doubt on the market's judgment about the future rate path.
Some economists warn that if the current degree of tightening proves insufficient to suppress price increases, the Fed may ultimately need to raise rates by more than investors anticipate.
The Fed will hold its monetary policy meeting in the early hours of Thursday Beijing time, with the federal funds rate target range currently at 3.75% to 4.00%.
According to a Reuters report on Monday, traders broadly expect rates to remain unchanged this week, and the CME FedWatch tool shows the market pricing roughly a 77% probability of a December hike.
Longer-term market pricing, however, is relatively dovish. Michael Kramer, founder of Mott Capital Management, noted that federal funds rate futures currently reflect a policy rate of about 4.5% by the end of 2027. In his view, current financial conditions are still not tight enough to ensure inflation returns to target, and the Fed may need to continue tightening policy.
Inflation pressures broaden as the economy has yet to cool markedly
U.S. consumer price index (CPI) rose 3.7% year-on-year in September, above the 3.4% gain in August, with a month-on-month increase of 0.6%. Core CPI, which excludes food and energy prices, rose 2.6% year-on-year, also higher than the previous month's 2.4%. The producer price index (PPI) rose 1.3% month-on-month, the largest single-month gain in four years.
Corporate surveys released last Friday further showed that price pressures are spreading to more industries. The preliminary S&P Global U.S. composite purchasing managers' index (PMI) for October fell to 57.6 from 58.4 in September, but the new orders index rose to 58.2, the highest level since March 2022. The business output prices index climbed to 59.8 from 58.4, the highest since August 2022.
Chris Williamson, chief business economist at S&P Global Market Intelligence, pointed out that worsening supply chain bottlenecks and rising backlogs are making it easier for companies to pass on higher costs to consumers.
Household inflation expectations have also risen. A University of Michigan survey released last Friday showed that U.S. consumers' one-year inflation expectation rose to 4.7% from 4.6%, while the five-year expectation increased to 3.5% from 3.4%. The consumer sentiment index, meanwhile, fell to 48.0, close to a record low.
Economic activity still shows some resilience. The Atlanta Fed's GDPNow model estimates that U.S. economic growth in the third quarter could reach an annualized 3.5%. That forecast has yet to be confirmed by official data due this week, but business investment and consumer spending suggest uncertainty remains over whether the economy can cool sufficiently at current interest rate levels.
Upside risk to where the hiking cycle ends
Beyond inflation data, whether financial conditions are truly tightening is becoming an important basis for judging the strength of the Fed's next policy moves. Kramer noted that the Chicago Fed's National Financial Conditions Index is currently around -0.50, still at a historically relatively loose level. Although financial markets have begun to reflect expectations of monetary tightening, credit spreads remain low, and U.S. equity valuations had been expanding, indicating that policy has not yet sufficiently constrained the overall financial environment.
In his judgment, if inflation is to fall sustainably back to 2%, the Fed may need to push financial conditions to tighten further. If the market reassesses the scale of future rate hikes as a result, credit spreads could continue to widen and stock volatility could rise.
Still, some parts of the financial markets have already seen notable adjustments. The U.S. 10-year Treasury yield briefly broke above 5.3% this month, a more than 20-year high, before pulling back as AI-related stocks came under pressure and the market reassessed the growth outlook. Mortgage rates remain above 7%, and the housing sector and some high-risk corporate borrowers already face higher financing costs.
Claudia Sahm, a former Fed economist and chief economist at New Century Advisors, argued that the Fed should not rely excessively on financial markets tightening on their own. The recent sharp swings in bond yields show that market-driven financing constraints can change rapidly.
Institutions warn tightening may not be enough
The Fed raised rates by 25 basis points in September, its first increase in 2023. But with inflation still elevated, officials have recently preferred to slow the pace of action. Bloomberg reported on Sunday that after the October inflation report was released, traders briefly pushed the probability of a hike this month to nearly 50%, but expectations quickly retreated as Fed officials continued to send cautious signals. As of last weekend, interest rate swap markets reflected a less than 15% probability of an October hike.
Fed Chairman Kevin Warsh said on the 16th of this month that he would not prejudge the outcome of any policy meeting and reiterated his reluctance to commit in advance to future rate actions. Other officials, however, have repeatedly said there is no need to rush further hikes, helping the market gradually form a consensus that the Fed will pause in October.
Views among institutions on the size of further hikes are widening. A Reuters survey published on October 20 showed that 94 of 100 economists expect rates to stay unchanged this month, while all 100 expect a hike in December. Among the 92 economists who answered the question on the peak rate, 38 expected at least two more hikes, up from about one-fifth in the September survey.
Michael Gapen, chief U.S. economist at Morgan Stanley, warned that growth and inflation risks are tilted to the upside and that the Fed may ultimately need to raise rates by more than the bank expects. Jason Schenker, president of Prestige Economics, previously also suggested that if September's hike fails to noticeably curb inflation, the Fed may consider a single 50 basis point increase in December, rather than the usual 25 basis points.
But not all institutions believe the degree of tightening needs to increase. Bloomberg Economics still expects the Fed to keep rates unchanged through year-end, arguing that higher borrowing costs are gradually transmitting to the real economy and that an adjustment in AI-related assets could cause financial conditions to tighten abruptly. The rate decision in the early hours of Thursday Beijing time and Warsh's subsequent press conference will be important reference points for the market in judging the policy path. On Thursday, the U.S. will also release its preliminary third-quarter GDP reading and the September personal consumption expenditures (PCE) price index, an important gauge of inflation for the Fed, providing fresh data for policy judgments at the December and subsequent meetings.
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