The Federal Reserve is widely expected to raise interest rates Wednesday for the first time in more than three years, but some economists say a hike would be a mistake.
The Fed is expected to lift its benchmark rate by a quarter of a percentage point to 3.75%-4%. Fed-funds futures traders put the odds of a hike at 91%, up from just 30% ahead of the central bank's July meeting, according to the CME FedWatch tool.
Yet, the debate around the correct monetary policy path is far more nuanced than the probabilities suggest. While many Fed watchers see valid reasons for officials to raise interest rates this week, others say it would be the wrong move, given the current inflation backdrop.
"Hiking is the wrong choice," write Standard Chartered Bank's John Davies and Steve Englander. "The correct Fed policy decision in our view is straightforward - stay on hold until the noise from tariffs and data revisions dissipates."
Persistent inflation remains the driving force behind calls for a rate increase both within and outside the Fed. Prices have grown in excess of the Fed's 2% annual target for more than five years, as measured by the central bank's preferred gauge, the personal consumption expenditures price index. For August, Citi economists estimate that core inflation, which strips out food and energy prices, rose 3.1% from a year earlier. The three-month annualized pace of core PCE inflation should slow to 2.9% from 3.3%.
The data don't suggest a clear mandate, however, and methodological changes that the Bureau of Economic Analysis is set to implement on Sept. 30 are expected to result in a lower PCE inflation reading. PCE inflation hasn't moved up or down decisively in recent months, Davies and Englander say, while noting that core inflation trends have likely been overstated due to "idiosyncratic factors" such as tariffs playing an outsized role.
Three- and six-month measures of core inflation have eased relative to prior periods and there are no signs that medium- or long-term inflation expectations are on the rise, writes EY-Parthenon Chief Economist Gregory Daco, who is also in the "hold" camp. Additionally, he writes that employment conditions don't appear to be adding to inflationary pressures. With real wages declining over the past three months, the labor market is a source of disinflation, he says.
David Mericle, chief U.S. economist at Goldman Sachs, similarly has questioned whether conditions merit a rate increase in September. He is unconvinced that the Fed has a strong economic case for raising the fed-funds rate, he wrote recently, adding that the persistence of elevated inflation can be attributed to "one-time factors whose impact is likely to fade," including higher tariffs.
"The economy is not overheated, which is the usual rationale for raising rates," he wrote.
Concerns that artificial intelligence demand will stoke inflation in the next few years may also be abating, says Bernard Yaros, lead economist at Oxford Economics. Computer software and accessories prices declined by 2.2% in August, as measured by the consumer price index, following a soft reading in July. softer reading in July. Much of the bump in non-housing core services in the August CPI was driven by oil supply shocks or temporary factors, such as an increase in wireless telephone services.
"The fundamentals still give the Fed some space to stay on hold - even if it chooses not to take that space," says Julia Hermann, global market strategist at New York Life Investment Management.
Oil prices topped $104 a barrel on Tuesday amid more supply disruptions in the Middle East. Yet, even higher energy prices may be temporary-and deflationary.
"It is a reasonable bet that a deal will be struck after the midterms to allow both Iranian oil and oil from the other Gulf states to flow through the Strait [of Hormuz]," wrote David Kelly, chief global strategist at J.P. Morgan Asset Management. "In the meantime, higher oil prices will further depress other areas of consumer spending exerting downward pressure on core inflation."
Kelly says Fed Chairman Kevin Warsh painted himself into a corner regarding a rate increase because of credibility concerns, not economic fundamentals.
"In the absence of forward guidance, the market groupthink has coalesced around a rate hike this week and if the Fed doesn't deliver one, both Chairman Warsh and the FOMC will lose serious credibility," he wrote.
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