FOMC Watch – A hike of caution, not conviction

Our base case is that the Federal Reserve will raise rates by 25bp at Wednesday's FOMC meeting. Only a week ago, we were still on the other side of that call. In our Global Monthly, we argued that although support for a hike had been growing, we did not see a majority of voting members willing to tighten policy while inflation continued to make gradual progress towards target. The committee appeared balanced, with a hawkish minority advocating immediate action, but a larger group still comfortable remaining on hold as long as disinflation remained broadly intact. The August CPI report has likely shifted that balance. Crucially, however, it has changed the likely outcome of the meeting more than it has changed the fundamental economic outlook. Core inflation came in firmer than expected, but annual core inflation continued to fall, and much of the upside surprise was concentrated in a handful of categories. The report did not, by itself, alter the inflation story, but it did make it harder for the centre of the committee to justify waiting for further evidence, given their own previous communication.

A hike this week therefore should not be interpreted as a Fed suddenly concluding that inflation is back out of control. Inflation expectations remain broadly anchored, the labour market shows little sign of overheating, and recent inflation pressures have been driven primarily by supply-side developments rather than excessive economy-wide demand. Hiring remains subdued, while labour supply dynamics continue to explain much of the apparent resilience in employment. Rather, it reflects a committee that has become somewhat less confident that inflation will continue to fall unassisted. The likely majority appears to have concluded that the risk of doing too little has risen relative to the risk of doing too much. In that sense, we see a hike is as an exercise in risk management rather than the start of a forceful tightening cycle.

That would be far more in line with what monetary policy can and cannot achieve. Monetary policy cannot reopen the Strait of Hormuz, restore refinery capacity or lower energy prices (see also our recent scenario update). To the extent that recent inflation pressures originate in commodity markets and supply disruptions, the Fed has little influence over their source. What it can influence is how those costs are absorbed throughout the economy. After six months of elevated energy costs, businesses increasingly face a choice between raising prices and accepting lower margins. By moderating demand, tighter policy reduces firms' ability to pass costs on to consumers and increases the likelihood that part of the adjustment is absorbed elsewhere. More broadly, it lowers the risk that an initial supply shock becomes embedded in broader inflation dynamics. The case for a hike is therefore less about bringing inflation down directly and more about preventing inflation from becoming more persistent.

Importantly, that conclusion does not automatically imply further tightening. The conditions that justify a hike now are not necessarily the conditions that justify another hike later. One or two members may have moved into the hiking camp following the CPI report, but that does not mean they have signed up to a sustained tightening cycle, let alone the four hikes currently priced by markets. If inflation resumes its gradual decline, the case for further hikes will weaken considerably. If inflation proves more persistent, broadens across categories or begins to affect expectations, the argument for additional tightening will strengthen. The path from here remains highly conditional on incoming data. We have pencilled in a single additional hike in the December meeting, based on similar considerations as the first hike.

That leaves Chair Warsh with a difficult communication challenge. Since taking office, he has generally prioritised flexibility over clarity. While that approach preserves optionality, it has often left markets with an incomplete understanding of the committee's reaction function. The July press conference in particular raised more questions than it answered about how policymakers were weighing continued inflation progress against the risk that progress could stall. The Jackson Hole speech clarified the reaction function somewhat, but this week’s meeting will actually reveal its implications.