No Need for the Fed to Rush to Hike
The Federal Open Market Committee (FOMC) will meet this week, and the swaps market thinks there’s a significant chance it will decide to hike rates.
The CME Group’s FedWatch tool, which uses prices of federal funds derivatives to calculate the implied odds of Fed policy moves, shows a 37.9 percent chance of a hike this week and a 62.1 percent chance that the Fed remains on hold. That’s around the same odds the market was implying on Friday but very different from just a week ago, when the derivatives market was implying just a 16 percent chance of a hike.
The Hawkish Case Isn’t Baseless
The case for a hike is straightforward if not decisive. Inflation is well above target, and the labor market looks solid. The consumer price index (CPI) for June showed prices up 3.5 percent from a year earlier, even though the monthly number was softer than expected. If you combine that with the personal consumption expenditure price index, relevant data from the producer price index (PCE), it’s likely that the PCE index that the Fed officially targets is running around 3.3 percent year-over-year. The unemployment rate in June was 4.2 percent, and jobless claims came in at 187,000 for the week ended July 18, the lowest since the late 1960s. Even though the payrolls growth figure came in lower than expected at 57,000 in June, it is still above most estimates for the break-even rate of jobs growth.
Neil Dutta at Renaissance Macro argues that the minutes from the last Fed meeting augur a hike. They appeared to lay out three developments that could trigger a hike. First, the persistence of strong AI-related demand. Second, pressure on the price indexes from the conflict with Iran. Third, tariff effects that many Fed officials believe put upward pressure on consumer prices. If those are the criteria for a hike this week, all three seem satisfied.
There’s also a political calculation that officially everyone will deny factoring into the decision but may weigh on Fed officials nonetheless. When the Fed cut rates in September of 2024, on the eve of the election, the move was widely perceived as a political endorsement of Joe Biden, a signal that the Fed was no longer as concerned about inflation. That might not have been entirely fair—Fed officials claimed they were worried about the labor market, which is the opposite of an endorsement of Biden’s policies—but the perception stung. A hike now could avoid the photographic negative: a Fed increase in September on the eve of the midterm elections.
Finally, some have argued that the committee may be significantly more hawkish than Chairman Kevin Warsh, at least at the moment. According to this line of reasoning, Warsh might agree to increase the fed funds target rate in order to buy credibility with the committee and markets, displaying independence now in order to better control Fed policy later. President Trump’s decision to praise Warsh while arguing that other Fed officials have “bad intentions” could add to the pressure on Warsh to demonstrate his independence with a hike.
But the Market Has Already Tightened
So why isn’t the market pricing in an even greater chance of a hike? For one thing, the softer-than-expected June CPI numbers—headline CPI declined 0.4 percent month-over-month—took away some urgency for the Fed to act. Although that was driven by falling energy prices, underlying inflation figures were also benign. Median CPI rose just 0.2 percent for the month and is up 2.7 percent year-over-year. The Cleveland Fed’s 16 percent trimmed-mean inflation figure was flat for the month, and it is up 2.6 percent on a 12-month basis. Those figures give the Fed breathing room. It can hold off to see where inflation comes out.
There’s also the fact that the longer-term rates that reflect the prices of credit for household and business borrowing are already doing some of the work of a hike. The 10-year Treasury yield is around 4.65 percent, up from 4.16 percent at the start of the year. The average rate of a 30-year fixed mortgage is up to 6.58, the highest in nearly a year. If the market is already tightening financial conditions, the Fed can afford to sit back and wait to see how the economy develops in the months ahead.
Then there is the risk that a hike now, after the soft inflation reports for June, could convince the market that the Fed is setting off on a rate-hiking cycle rather than a mid-cycle adjustment. That could push longer rates into unduly restrictive territory.
We expect that the FOMC will ultimately stay on hold this meeting, with the bulk of the committee deciding that policy can afford to wait to see how geopolitics and the U.S. economy develop in the months ahead rather than rushing into a hike amid uncertainty.
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