Markets widely expect the Fed to hike rates by 25bps at the conclusion of its 2-day policy meeting on Wednesday. But the market isn’t fully convinced, leaving room for two-way action after the decision. Gold could prove the most vulnerable asset, not just because of the decision itself, but because of what comes after. Markets are nearly evenly split on a second rate hike in October. How that plays out could be decisive for the market reaction.
Markets recently raised their projections for a rate hike after Friday’s inflation report. The headline numbers largely matched expectations. However, a slightly hotter-than-anticipated August core CPI reading (0.3% vs 0.2% forecast) pushed the odds of tightening higher. Many analysts see the September meeting as a major test of new Fed Chair Kevin Warsh’s inflation-fighting credibility. Many Fed watchers say he has talked tough on controlling consumer prices. Now, it’s time to put that rhetoric into action.
What to Expect From a FOMC Hike
Futures markets now see an 87% chance of a rate hike on Wednesday, up from under 60% before the data came out. Economists are near unanimous as well. Therefore, most of the upside for the dollar and downside for gold is already priced in ahead of the rate decision. The main focus will be on what comes after. Markets will watch whether Warsh maintains his anti-inflation rhetoric after delivering the first hike of his tenure. This comes despite his appointment by the notoriously dovish US President Donald Trump.
The odds of a subsequent hike at the November meeting are over 40%, indicating considerable uncertainty. If the market expects back-to-back hikes, the dollar could get a bigger boost following the decision and Warsh’s comments. On the other hand, Warsh could signal a likely pause to assess the impact of the rate hike. In that case, lower odds of November tightening could see the dollar giving back some of its upward move. Gold could rise in relief as well.
Not Everyone is Convinced of a Hike
There is still a chance of a dovish surprise that could substantially drag on the dollar and boost gold. Not many economists share this view. However, there are reasons the Fed might forgo a rate hike on Wednesday. Such a move would likely bring a substantial number of dissenters.
The strong August jobs report and headline US CPI data have been front and centre for traders. They have contributed to the high odds of a hike. At the same time, core inflation has recently declined. This suggests that higher energy prices haven’t passed through much into the economy. Although the jobs numbers are back in triple digits, they remain below previous years’ averages. This indicates that the labour market is not in full growth mode.
More importantly for the Fed, average wages are slowing, and so is the broader economy. A hike raises the risk that inflation could undershoot, creating deflation. The Fed is much more concerned about deflation than other major central banks. Deflation has been a bigger problem for the US historically.
How the Market Will React to the FOMC Decision
Given the high odds of a hike and the expectation of further hikes, the market has likely already priced in much of the upside from the decision. This leaves the risk balance skewed toward the downside.
A more hawkish Fed might support the dollar. However, the market could also become concerned that higher rates will drag on the stock market and reduce foreign investment demand. That would likely weaken the dollar.
