When the Federal Open Market Committee meets this week to deliberate its next policy move, it will find itself between a rock and a hard place: a stubbornly high inflation rate, which ran at 8.3% in August, is very close to its 40-year high of 9.1% in June; and a slowing domestic economy, as evidenced by the Fed’s recent Beige book edition, which finds that economic activity in the 12 districts covered by the Fed’s regional branches has slowed down.
That’s consistent with a string of real GDP reports suggesting that the U.S. economy may already be in a recession.
Then there’s the global economy, which is heading into a recession, according to data from the World Bank, and international shipping companies, like FedEx, which sent a chilling message to Wall Street last week.
Under these circumstances, the Fed faces a dilemma: go with a 100bps hike to bring inflation under control and risk pushing the economy into a recession, or a 50-75bps hike to save the economy from falling into a recession, but risk losing credibility in the fight against inflation.
So, which is the most viable solution to this dilemma?
Anessa Custovic, the chief investment officer at Cardinal Retirement Planning, thinks that a 75bps hike is the most likely scenario, pointing to Fed futures. They assign an 80% probability to a 75bps interest rate hike and a 20% probability to 100bps.
“It is all but certain that we will see a 75 basis point hike on Wednesday when the Fed meets for its FOMC meeting,” Custovic told International Business Times in an email. “The door is open for a 100 basis point hike, but I don’t think they will take it. I don’t see a scenario in which the Fed will go below 75 basis points. They will be seen as accommodative if they do any less, which will greatly reduce their credibility.”
Thomas Samuelson, the chief investment officer at Vineyard Global Advisors, sees the likelihood of a 75bps even higher than 80%, following the substantial inflation numbers reported on Tuesday.
“The market is placing 85% odds on the Fed increasing interest rates by 75 basis points on Wednesday of next week (from 2.5% to 3.25%) and 14% odds that it will hike by a more dramatic 100 basis points,” Samuelson said. “Expectations for future rate hikes have also increased with the market now expecting at least 200 basis points of additional hikes through March of next year vs. only 150 bps earlier this month.”
Dan North, a senior economist at trade credit insurer Allianz Trade North America, thinks that the Fed will continue on its “take no prisoners” approach to inflation next week, hiking interest rates by 75bps. He points to the probability of the 100 bps, which has risen to 38% since the last Consumer Price Index report.
“Whether it’s 75 or 100 basis points, the Fed is driving the economy towards recession,” North said.
Yohay Elam, a senior financial analyst with FXStreet, is with the 75 bps camp, too.
“I expect the Fed to raise rates by 75 bps as it initially signaled, refraining from a late shift to 100 bps,” Elam said. “While high underlying inflation shocked markets, it does not warrant a quadruple-sized increase in borrowing costs.”
How would that affect the equity market? It depends on how higher interest rates and a slowing domestic and global economy affect corporate earnings.
Samuelson expects S&P 500 earnings to rise 1% this year, from $208.21 per share to $209.76 per share. That’s compared to declines of 5% to 20% typically seen during economic contractions.
“We have been expecting downward earnings revisions this year as the deteriorating macro environment has been flagged by many leading indicators, including an inverted yield curve, widening credit spreads, and deteriorating stock market breadth,” Samuelson said.
