MNI STATE OF PLAY: Fed Eyes Third 75BP Hike, Higher Peak Rates

The Federal Reserve on Wednesday is widely expected to lift its overnight borrowing rate by 0.75 percentage point for a third straight meeting and signal a higher peak for interest rates next year as inflation continues to move sideways at a level more than triple its 2% target.

The move would take the federal funds rate to a 3%-3.25% target range for the first time since 2008. Accompanying that decision, a quarterly refresh of the FOMC's economic projections will likely show a faster pace of tightening for the remaining months of 2022 and into 2023 than officials expected in June, as well as lower growth and higher inflation and unemployment.

The new "dot plot" is likely to show rates rising to 4% or above by year-end and peaking at around 4.5% in 2023, former Fed officials and staffers told MNI, though many believe rates will ultimately need to rise to 5% or higher, more than futures markets are pricing. Fed funds implied rates peak in March 2023 at 4.5%, just a tad above 4.25% in December.

The June dot plot had penciled in rates at 3.4% by year-end and 3.8% by end-2023.

STUBBORN INFLATION

Both headline and core CPI accelerated in August against expectations for a small fall in prices on lower gas prices, stoking fears that the Fed will have to do more to shift inflation dynamics, even at the risk of tipping the economy into recession.

Cleveland Fed president Loretta Mester said on an MNI webcast this month it's far too soon to conclude inflation has peaked. Various indicators on the Fed's inflation dashboard suggest core CPI may be stabilizing at around 6% while underlying trend for PCE inflation, the Fed's preferred gauge, is just between 4.25%-4.5%.

Policymakers are keen to make sure higher expectations of inflation do not become entrenched among businesses and consumers. Consumer expectations showed tentative signs of turning down but that easing provides little comfort since volatile energy prices may be the driving force, Johanne Hsu, head of the University of Michigan Survey of Consumers told MNI.

ECONOMIC HARM

Fed officials could take the opportunity this week to hint at some of the pain that's likely to come with higher rates, but are unlikely to project a downturn or an unemployment that rises much above 4.5%, said Jonathan Wright, a former economist at the Fed Board's monetary affairs group.

“We think we can avoid the very high social costs that Paul Volcker and the Fed had to bring into play to get inflation back down,” Fed Chair Jerome Powell said in an interview at the Cato Institute earlier this month, referring to the double-digit interest rates and sharply higher unemployment of the 1980s.

“What we hope to achieve is a period of growth below trend, which will cause the labor market to get back into better balance, and then that will bring wages back down to levels that are more consistent with 2% inflation over time.”

QT

The FOMC's plan for reducing its USD9 trillion balance sheet ramped up to full speed in September, with up to USD60 billion of Treasuries and USD35 billion mortgage-backed securities maturing every month, and officials have signaled no plans to alter that program.

Mester told MNI she's more concerned about the potential for QT to constrain market liquidity than its effect on financial conditions and supports allowing the run-offs to continue on autopilot.

However, some investors and a former regulator have warned QT could have a much larger tightening effect than the Fed expects, especially if growth slows dramatically.

Former Reserve Bank of India Governor Raghuram Rajan, in a paper presented at the Jackson Hole monetary policy conference last month, also said the Fed may be too complacent about the prospect that Treasury market liquidity will vanish in times of stress.