In A Nutshell: After last week’s inflation data, markets are almost certain a Fed rate hike is coming this Wednesday, but the economic case is far from a slam dunk. And the effect of a hike on mortgage rates is uncertain.
Last Week’s Highlights
The main event last week was Friday’s CPI data, which came in high with monthly core inflation at 0.29% vs 0.22% expected. Coupled with a firm reading on producer prices on Thursday, forecasts for core PCE, the main inflation metric tracked by the Fed, hover around 0.25% monthly and 3.3% annually, which while not a five-alarm fire, is more likely than not to result in a Fed rate hike.
Similarly, the University of Michigan’s consumer sentiment data last Friday showed one-year-out inflation expectations among consumers rising from 4.2% to 4.6%, but five years out, expectations remain consistent at 3.3%. The same survey found a further decline in consumer sentiment to 47.8, an almost historically low level.
Upcoming Attractions
By far, the most important event on the calendar this week is Wednesday’s Fed meeting, which includes not only a decision on the policy rate and the Chairman’s press conference, but also a new set of economic and rate projections from all nineteen members of the committee. Following last week’s inflation data, markets have priced in a hike with over 90% probability and almost all Wall Street economists switched their call from “hold” to “hike”. The economic case for a hike feels significantly less certain than markets have priced. If the committee was not concerned enough about inflation to hike in July, the argument has hardly gotten stronger. Those in favor of waiting would argue that core PCE inflation has been moving in the right direction in recent months and much of the excess inflation above target is the result of one-time factors that we do not need monetary policy action to address.
However, the other side would argue that inflation has remained too high for too long and the three cuts last fall were a mistake in hindsight. Also, because Chair Warsh has chosen to communicate minimally with markets, he is now in a position where the Fed risks losing credibility if it does not deliver the hike markets are expecting.
Because the doves in favor of holding don’t hold their views as strongly as the hawks in favor of hiking, one middle-of-the-road option is that the Fed could hike on Wednesday but signal fewer additional hikes than markets are expecting for the rest of the year. Another hike has been priced in by year end, which makes sense since the Fed has only ever done a “once and done” hike once, but financial conditions have tightened significantly in recent weeks resulting in the 10 year yield sitting at 5% and the committee may be reluctant to nudge rates any higher.
Whatever they ultimately decide to do, the reaction in bond markets is hard to predict because it depends on the policy action itself, the forward projection, and whether markets believe the Fed is serious about 2% inflation.
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