The Fed will need to step up its fight against inflation

The upside shock in the US August inflation reading will cement in a 75bps hike at next week’s FOMC meeting and bring the Fed Funds rate up to 3.25%. No statement from policymakers will be forthcoming until after the FOMC as the Federal Reserve is currently in its blackout period, so markets will be focusing carefully on any leaked comments to journalists for instance, similar to how the Fed stealthily prepped markets for their 75bps hike in June.

Current market pricing—based on options and futures—indicates there is even some chance of a 100bps hike next week which would bring more of the Fed’s firepower to bear on fighting against inflation. The August CPI print showed just how challenging it is for the Fed to “un-entrench” high inflation; every component rose month/month apart from fuel costs as oil prices extended their decline in August. Housing, medical services, food at home and away, furnishings and clothing were among the contributors to the month/month gain, indicators that will take time to be affected by higher borrowing costs.

After a relatively sanguine summer and a few days recently of hoping that peak inflation was firmly in the rearview mirror, markets will need to adjust to the prospect of inflation staying elevated for longer and that the Fed will need to match it with aggressive policy tightening. Market pricing for the Fed Funds rate in 2023 now has a peak around 4.3% in Q1 next year compared with 3.9% at the start of September. Along with the rate decision next week, the Fed will also publish a new Summary of Economic Projections including a new dot plot. The June SEP had a median Fed Funds rate of 3.8% for 2023 and that is likely to shift higher as the inflation challenge is that much more pressing and the economy still appears to be holding up relatively well.

A 75bps hike at the September FOMC appears a given and there is a strong chance of 75bps at the November meeting as well though we will get another inflation, jobs and GDP print before then for the Fed to consider. For now, we will hold our view that the Fed hikes by 50bps in November and December though the risks are overwhelmingly on the upside given how sticky inflation appears to be and how relatively robustly the economy is performing. We also project at least two 25bps hikes in 2023 which would bring the Fed Funds rate up to 4.75% by the mid-point of next year at which point they will likely pause before considering any easing in policy.