Forex Trading Library

Fed To Skip, If Inflation Allows

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Over three-quarters of traders expect the Fed to hold pat tomorrow. But that could radically change with the data coming out later today. Given the impact of inflation on the Fed’s potential decision, the market might actually react more to the CPI than to the rate decision itself.

The potential for a large market reaction is that current expectations are based on something unprecedented: A Fed rate “skip”. Other central banks have announced “pauses” that had to be reversed a few months later. The Fed is intent on assuring the market that it won’t stop hiking. Meanwhile, the Fed’s projections for where rates will be at the end of the year is radically different from the market’s. All of this boils down to a shaky consensus around what could be just a couple of decimals difference in the data.

What’s the difference between a “skip” and a “pause”?

Usually, central banks don’t say they are “pausing”. Rather, they put in some technical speak, saying something along the lines of maintaining current policy depending on the data. If there had been a series of rate hikes prior, this language is understood to mean more hikes are possible, but the bank isn’t inclined to do them now. As a rule of thumb, a “pause” implies that rates can be kept at this level for a while.

The concept of a “skip” was introduced by a couple of Fed officials late last month. It implied that the Fed is still in a rate hiking trajectory, but will opt to not hike at the current meeting. This sort of communication hasn’t been done before. The implication is that the Fed will not raise rats, but will heavily imply that rates will go up at the next meeting. So, while a skip and a pause both mean that there is no rate hike this time around, they differ in how strong the message for a rate hike at the next meeting is.

Fighting the Fed or fighting the market

This slight difference can have a bigger impact on the market, depending on the data. It’s not a big change in outlook to move from expecting a skip to a pause. Likewise, it’s not a big change in the outlook to expect a rate hike now instead of at the next meeting. But both of those options can have a big impact on the price of the dollar, since either option would imply a larger shift in treasury yields.

Therefore, a lot is riding on the inflation data coming out later today. Higher inflation would imply no skip; lower inflation might incline the balance towards a pause. For that reason, there could be more market volatility with the data release than with the interest rate decision. If inflation data is within expectations, then the big market move could be on Wednesday.

What the data says

Headline inflation is expected to come down substantially to 4.3% compared to 4.9% prior, which is likely to get the mass media headlines. But the Fed cares about the core rate, and here things are a lot more dicy.

Core annual inflation is expected to tick down just one decimal to 5.4%. That means if it beats by just two decimal points – something rather common – it would imply that core inflation has turned around and is heading higher. That could really worry the Fed, and might dramatically shift the odds of a rate hike. Whereas core inflation being below expectations would likely consolidate the odds of a skip if not a pause, and weaken the dollar.

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