The Fed is widely expected to keep rates unchanged at the conclusion of its policy meeting on Wednesday. But the outcome and the effect on the market could be complicated by a few factors. The one getting the most attention now is the potential effect of the war in the Middle East on inflation. The dollar is rising, and gold is falling as traders bet that higher fuel prices will force the Fed to keep rates at least at the current level for a while, if not potentially hike in the future.
However, there are deep divisions within the FOMC, and the current situation could exaggerate them. While higher crude prices would likely have the first impact of higher inflation, they would also likely slow the economy. This would bring the Fed’s second mandate to maintain full employment into focus, particularly after February’s dismal jobs report. That means the market could be shocked by what happens at the upcoming meeting.
Markets to Focus on Dot-Plot, Not Powell
The current futures pricing suggests no possibility of a change in rates at this FOMC meeting on Wednesday or the next. Normally, that would lead to a relatively muted market response. But the complicated scenario means traders will be looking for clues about which direction the Fed is leaning. The Fed Chair’s post-rate decision press conference would have been a good place for that, but Powell will be replaced after the next meeting. That means his comments could carry less weight this time around.
Instead, traders are likely to focus on the dot-plot matrix, which is a summary of FOMC members’ rate policy projections. It is updated every three months, and the Fed will publish the new version along with the rate decision. This will also include the views of the new governors who rotated onto the Board this year, so it’s likely to show some changes.
Markets Pricing in a More Hawkish Fed
The prior version of the dot-plot matrix showed expectations for just one rate cut this year, likely around the summer. Up until the start of the war in the Middle East, markets expected two rate cuts in the same period, reflecting the typical situation where markets are more dovish than the Fed.
However, since crude prices spiked, markets have priced out rate hikes and now see only around a 50-50 chance of 25 bps of easing by December. This means the market is mostly expecting the dot-plot matrix not to show a rate cut this year. If that were the case, it would be a hawkish sign for the market and likely deepen the current trends. On the other hand, if the Fed keeps signalling a rate cut is likely, it could be seen as dovish by the market and reverse the dollar’s strength and gold’s weakness.
Parsing the Market Reaction
Before the war in the Middle East, the Fed was looking at a potentially growing economy with lower fuel prices and fading effects from tariffs. The main concern was when inflation would be low enough to cut rates. The war has radically shifted that situation, as consumer price increases now take centre stage.
That means traders will be looking closely at the monetary policy statement to see if the emphasis is put on inflation or the economy. If it’s the former, the market could take away a hawkish stance, even if the rate cut is still shown in the dot plot. On the other hand, if inflation from the war is seen as uncertain or transitory, then the market could see some dovishness in the outlook.
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