U.S. inflationary pressure has risen again and the economy remains resilient, but the Federal Reserve is expected to pause its rate hikes this week. Sharp swings in the bond market, officials' policy signals and disagreements over the pace of tightening have become key factors shaping the decision.
Nick Timiraos, known as the Fed's "loudspeaker," said the latest U.S. inflation data support further monetary tightening, but the Fed may still keep rates unchanged this week. As officials continue to send cautious signals, financial markets have sharply reduced bets on an October rate hike, and the policy focus is gradually shifting to December and the tightening path beyond. The Fed will hold its monetary policy meeting this week, with the federal funds rate target range currently at 3.75% to 4.00%. As of last Friday, interest rate futures markets put the probability of the Fed keeping rates unchanged this week at about 90%.
That expectation contrasts with recent economic data. The U.S. September Consumer Price Index rose 3.7% year on year, while the Producer Price Index rose 1.3% month on month. Economists expect the September Personal Consumption Expenditures price index due on Thursday to show a year-on-year increase of 3.6%, up from 3.4% in August, suggesting inflation may drift further from the Fed's 2% target. The U.S. economy has also yet to show clear signs of stalling. The September unemployment rate was 4.2%, initial jobless claims remained low, and artificial intelligence infrastructure investment and consumer spending continued to support economic activity. The market expects U.S. third-quarter economic growth may have accelerated somewhat. Kathy Bostjancic, chief economist at Nationwide, believes recent data show the U.S. economy, consumer spending and labor market remain solid while the inflation picture has worsened further, and from an economic fundamentals standpoint there is ample reason for a rate hike now.
Treasury yields swing sharply, prompting officials to slow their action
One important reason the Fed is inclined to pause is the sharp swings seen earlier in the U.S. Treasury market. After the Fed raised rates by 25 basis points in September, the U.S. 10-year Treasury yield quickly broke above 5% and later rose above 5.3%, the highest level in 24 years. Rising borrowing costs intensified market concerns about real estate, corporate financing and the economic growth outlook. Last Thursday, as technology stocks were sold off and funds shifted into Treasuries, the U.S. 10-year Treasury yield fell about 19 basis points in a single day to 4.95%, the largest one-day drop since the collapse of Silicon Valley Bank in March 2023. Bostjancic believes the earlier rapid rise in Treasury yields worried Fed officials because long-term borrowing costs could dampen the economy more than expected.
New York Fed President Williams and Fed Vice Chair Jefferson and other officials have said successively that the central bank can wait for more data before deciding whether to keep raising rates. The market then adjusted its expectations. Inflation data released in mid-October briefly pushed traders to increase bets on a hike that month, but Fed Chair Kevin Warsh said in a public speech on October 16 that economic changes since the September meeting were broadly in line with officials' expectations and did not actively correct the market's judgment that the Fed would pause. Robert Kaplan, former Dallas Fed president and now vice chairman of Goldman Sachs, believes the Fed had not done enough expectation guidance for an October hike, and keeping policy unchanged has now become the easier option to execute. Kaplan said that if officials believe the eventual amount of tightening needed is limited, then stretching the interval between two moves to six weeks still leaves the policy risk manageable. Jonathan Pingle, U.S. chief economist at UBS, also noted that raising rates at two consecutive meetings could lead investors to mistakenly believe the Fed is about to start a more aggressive tightening cycle than actually planned, while inflation has not yet shown the kind of runaway trend seen in 2022.
Officials disagree on the degree of tightening, and December hike expectations remain strong
Although the market widely expects a pause in October, there are still clear disagreements within the Fed over the strength of follow-up policy. Williams and San Francisco Fed President Daly had both previously described the September rate hike as a preventive measure against inflation risks. Daly once believed the Fed might still not need to raise rates further, but after the September CPI report she said the possibility of continuing to hike had exceeded that of not hiking. Other officials advocate more aggressive tightening. Dallas Fed President Logan believes the Fed needs to raise rates by at least another 50 basis points. Cleveland Fed President Hammack prefers smaller rate adjustments sooner to avoid being forced into a larger policy correction later. Logan and Hammack supported a rate hike at the July rate decision, and Minneapolis Fed President Kashkari took the same position. Analysts expect that if the Fed decides to keep rates unchanged this week, the meeting could still see dissenting votes in favor of a hike. Fed Governor Waller's stance is relatively middle-ground. He believes rate hikes do not need to happen at consecutive meetings, but the necessary policy adjustments should be completed within a reasonable time.
Institutional forecasts are also divided. Stephen Stanley, chief economist at Santander U.S. Capital Markets, expects the Fed to pause this week but raise rates again in December. Aditya Bhave, head of U.S. economic research at Bank of America, still predicts a possible surprise rate hike this week. Marc Giannoni, chief U.S. economist at Barclays, believes the artificial intelligence investment boom may continue to push up demand for energy, equipment and other resources, increasing the risk that price increases spread to more industries. If such investment remains strong, the Fed may need to do more to restrain economic demand.
With U.S. midterm elections approaching, policy communication faces a test
This week's policy meeting comes less than a week before the November 3 U.S. midterm elections, drawing even more attention to the Fed's decision. Gregory Daco, chief economist at EY-Parthenon, believes Warsh needs to explain the economic basis for pausing rate hikes at the press conference to avoid the impression that the policy decision was influenced by political factors. Fed officials have consistently stressed that monetary policy decisions are not affected by elections. However, with inflation persistently above target, if Warsh fails to explain why the Fed is holding off, the market may again question the central bank's determination to control prices. Warsh has repeatedly opposed excessive use of forward guidance, arguing that promising a future rate path in advance could limit policy flexibility. That also makes investors pay closer attention to how he describes inflation risks and changes in financial conditions. After this week's rate decision is announced, the market will first focus on whether Warsh still believes current financial conditions are restrictive enough and whether policy room remains for a December hike. A day later, the U.S. will release the preliminary third-quarter GDP reading and the September PCE price index. Before the December meeting, the Fed will also receive more employment and inflation data, providing a basis for judging whether it needs to keep raising rates.
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