Fed Chair Jerome Powell’s hawkish testimony this week means that the markets expect the Fed to raise rates 0.5-percentage-points on March 22. Specifically, fixed income markets now see an 8 in 10 chance the Fed makes a bigger move up in rates this month. Just last week, markets viewed it as far more probable that the Fed would make a smaller 0.25-percentage-point move. It’s been an abrupt shift as the Fed’s meeting approaches.
There are two main reasons for the shift, both concern inflation. The first is that January inflation came in higher than hoped. Now, Powell mentioned that may, in part, be due to unseasonably warmer weather, but there are concerns that recent trends that bought inflation lower in the second half of 2022, may have now largely played out, and resulting inflation remains well above 2%, the Fed’s annual inflation target.
In addition, that the Fed has worried for months that services inflation was running hot, specifically as Powell stated, “there is little sign of disinflation thus far in the category of core services excluding housing, which accounts for more than half of core consumer expenditures.” So headline inflation hasn’t fallen sufficiently, and service inflation remains elevated, hence the Fed’s worry.
Will We See A Larger Hike?
Ultimately, Fed Fund interest rates are determined by Fed policymakers, not market expectations, but the Fed manages market expectations closely. Even at the Fed’s February meeting the minutes revealed that some policymakers would have been comfortable with a 0.5-percentage-point hike, when rates actually rose by 0.25-percentage-points.
Still there are some important economic data releases between now and the Fed’s decision on March 22, which may alter the Fed’s assessment if the numbers deviate from expectations. Most importantly, we’ll see February CPI inflation data on March 14, but also receive further data on the jobs market and retail sales data before the Fed meets. Nowcasts have February CPI running at around 0.5%, if that forecast holds, implying an annualized inflation rate of 6%, then that may be sufficient justification for the Fed to make a 0.5-percentage move up in rates, especially if other data suggest the economy is running hot.
Perhaps a bigger concern, though, is that if the Fed’s recent rate hikes have not sufficiently controlled inflation. That may imply that it will take a recession to tame prices. That topic was the subject of a tense exchange between Chair Powell and Senator Elizabeth Warren during Powell’s testimony. Powell noted, under questioning, that the level of unemployment increase that the Fed recently forecast for 2023, has typically led to recession during U.S. post-war history.