There is no need for the Fed to rush to raise interest rates.
The Federal Open Market Committee (FOMC) is set to convene this week, but the swap market seems to strongly indicate a potential interest rate increase.
According to the CME Group’s FedWatch tool, which analyzes federal funds derivatives to assess the likelihood of the Fed’s policy actions, there’s a 37.9% probability of a rate hike this week, while a 62.1% chance suggests no change. This estimate reflects a similar outlook from Friday but marks a significant shift from just a week ago when the chances of a hike were only 16%.
The Hawk’s case is not baseless.
The argument for increasing rates is clear, though perhaps not entirely compelling. The current inflation rate continues to exceed targets, and employment metrics appear robust. The Consumer Price Index (CPI) for June indicated a 3.5% year-on-year increase in prices, though the monthly figures fell short of expectations. Alongside data from the Personal Consumption Expenditures Price Index and the Producer Price Index (PCE), inflation may be running around 3.3% year-over-year. Furthermore, the unemployment rate in June stood at 4.2%, and for the week ending July 18, 187,000 individuals filed for unemployment benefits—the lowest count since the late 1960s. Although job growth in June was below expectations by 57,000, it still surpassed most forecasts for necessary employment expansion.
Neil Dutta from Renaissance Macro notes that the minutes from the previous Fed meeting hinted at a possible rate hike. They identified three factors that could prompt an increase: sustained demand tied to AI, pressures on price indices from geopolitical tensions like those with Iran, and the potential upward impact on consumer prices from tariffs. Currently, all three conditions appear to be met.
Interestingly, there is a political calculation at play as well. Officially, members would deny it influences their decisions, but it might weigh on their minds. When the Fed lowered interest rates in September 2024 before the elections, it was perceived by many as a political move in favor of Joe Biden, suggesting that concerns about inflation were diminishing. It seems somewhat unjust—Fed officials maintain they prioritize the labor market, seemingly at odds with their political leanings—but the perception was still impactful. A rate increase now could potentially avoid the awkward scenario of the Fed raising rates right before the midterm elections in September.
Lastly, there are suggestions that the committee may currently adopt a more hawkish stance than Chairman Kevin Warsh would. This line of thought posits that Mr. Warsh may consider raising the federal funds target rate to establish his independence, preparing for better control of Fed policies in the future. President Trump’s support for Mr. Warsh, combined with his criticism of other Fed officials, might amplify the pressure on Mr. Warsh to take a more assertive approach.
But the market is already tight.
So, why isn’t the market reflecting an increased probability of further rate hikes? Well, the surprisingly low CPI numbers from June (with a month-over-month decrease of 0.4%) have eased some urgency for the Fed. This dip can be attributed to falling energy costs, though the core inflation stats still look positive. Notably, the median CPI saw a modest rise of 0.2% for that month and 2.7% compared to last year. The Cleveland Fed’s adjusted average inflation rate held steady at 16%, with no change monthly but up 2.6% annually. These indicators provide the Fed some leeway, allowing them to hold off a bit to see how inflation trends evolve.
Moreover, there’s the reality of long-term interest rates affecting financial conditions. The yield on the 10-year U.S. Treasury has climbed to around 4.65%—up from 4.16% at the year’s start—and the average interest rate for a 30-year fixed mortgage recently hit 6.58%, the highest in nearly a year. With financial conditions already tightening, the Fed might find it prudent to adopt a wait-and-see approach to gauge the economic landscape over the coming months.
Additionally, there’s a risk that raising rates now, especially after June’s disappointing inflation figures, might lead to perceptions that the Fed is on the verge of a rate hike cycle rather than making mid-cycle adjustments. If this occurs, it could push long-term interest rates into a disproportionately restrictive territory.
Ultimately, the FOMC seems set to conclude this meeting with a majority likely opting to hold off for the moment. They can afford to wait, avoiding hasty interest rate increases amid ongoing uncertainties, particularly around geopolitical developments and the state of the U.S. economy in the near future.
