Chief Global Strategist
In the Broadway musical, Fiddler on the Roof, Tevye, the well-meaning patriarch of a poor family, has to make some tough choices in a complicated time. Tevye, (who always reminded me of my father-in-law, Bill), has trouble deciding and three times during the play the music comes to a halt as he wanders through a long soliloquy of “on the other hand’s”.
The Federal Reserve also has a tough choice to make in a complicated time. We now believe that they will raise rates this week. However, it is important to understand the logical twists and turns needed to reach that conclusion in order to trace out a potential path forward for the economy, interest rates and asset class returns.
To bring some structure to the argument, the issues can be divided into three sections: the economy, the FOMC itself and the importance of Fed credibility.
The economy – hot or not?
One reason for rising expectations of a Fed rate hike has been a renewed surge in oil prices.
The war with Iran continues, with conflicting reports about how much oil is slipping through the Strait of Hormuz each day. However, there is no dispute that traffic is down very significantly from pre-war levels. Moreover, with Houthi rebels exercising control over the Bab-al-Mandab waterway at the entrance to the Red Sea and Saudi Arabia shutting down a key east-west pipeline in response to attacks, the widening conflict is continuing to severely constrain energy exports from the Middle East. Consequently, as this is being written, WTI crude oil is selling at $104 per barrel compared to $84 on July 29th, when the FOMC last met.
Iran has little incentive to negotiate ahead of the U.S. mid-term elections and so higher energy prices could feed through to higher headline inflation in the months ahead. We now expect headline PCE inflation to still be as high as 3.5% year-over-year in December, but….
…On the other hand….an oil price surge is a classic temporary supply shock. It is a reasonable bet that a deal will be struck after the midterms to allow both Iranian oil and oil from the other Gulf states to flow through the Strait. In the meantime, higher oil prices will further depress other areas of consumer spending exerting downward pressure on core inflation.
Equally importantly, there is no evidence that energy-induced inflation has changed long-term inflation expectations in a meaningful way. The expected CPI inflation rate over the next 10 years, implied by the yield difference between nominal Treasuries and TIPs, is 2.36%, up just 0.11% since the start of the year. Since CPI inflation has run an average of 0.32% above PCE inflation over the past 20 years, this suggests the Treasury market still expects the Fed to, on average, hit its 2.0% PCE target over the next decade.
(As a small sidebar, it could be noted that year-over-year core PCE inflation in July was actually 0.9% above the reading for core CPI. However, this was largely due to the temporary effects of methodology differences between the two measures in the areas of health care, housing, insurance and financial services which will should, in any event, resolve themselves fairly quickly and also be partly addressed in the annual revision to the GDP accounts at the end of this month.)
Fed hawks could also point to the strength of the August employment report or third-quarter GDP growth projections as signs of building inflation pressures. The economy added a solid 162,000 payroll jobs in August and the unemployment rate remained unchanged at 4.1%, tying July for the lowest reading seen since January 2025. In addition, the Atlanta Fed’s GDPNow model is forecasting a booming 4.4% growth rate for the third quarter….
…..On the other hand….the payroll job jump came after two particularly weak months so the 3-month moving average gain is just 71,000. The unemployment rate is low, but that is, to a large extent, because of immigration restrictions and the aging of the baby boom which has led to a 973,000 decline in the labor force over the past year – hardly a sign of a hot economy. Most importantly, year-over-year wage growth came in at just 3.1% for August – the weakest gain in any month since May 2021 and the fifth consecutive month in which real wages fell year over year. With a backdrop of solid productivity growth, there simply isn’t any evidence that a tight labor market is translating into accelerating labor costs.
Finally, on economic growth, while we expect a bounce in third-quarter GDP growth, this is mostly due to an inventory swing following five consecutive quarters of falling stockpiles. With no further fiscal stimulus likely, with weak demographics hurting job growth, housing and consumer spending, and despite a continued AI capital spending boom, we expect real GDP growth to slow to a pace of just 1.5% to 2.0% from the fourth quarter of 2026 to the end of 2027.
Reading the Dots
Another strand of the argument for a rate hike this week centers on the “dot plot” released with the June FOMC meeting. At that time, of the eighteen FOMC participants that submitted projections, eight wanted no change in rates by the end of the year and one wanted a 25-basis point cut. However, in the raising rates camp, three wanted to see one rate hike, five wanted to see two rate hikes and one wanted to see three rate hikes. In other words, the hawks were more hawkish than the doves were dovish and the median dot was assessed to be in favor of one hike this year…
…On the other hand…Only eleven of the eighteen members who submitted projections in June are actually entitled to vote at FOMC meetings this year. When we analyze the various interviews and speeches of those eleven, we believe that eight of them may have been in the hold or cut camp. If this is the case, then, assuming Kevin Warsh would now vote for a hike, three more would have to change their minds to provide the necessary majority to raise rates. (Note that in the case of a six-six tie on a proposal to change rates, the proposal would fail and no change would occur.) This is a high bar given the conflicting evidence on the outlook for inflation, employment and economic growth noted earlier.
It would also be awkward, to say the least, for the Fed Chairman to raise rates given the campaign the President waged against his predecessor because he wouldn’t cut them. This is particularly the case because of the relatively dovish comments Kevin Warsh made about inflation before he was confirmed….
…On the other hand….if we were to go down a political path, some members of the committee might be tempted to raise rates just to retaliate against the administration for its attacks on Fed independence and individual Fed officials.
However, on balance, we believe that the Fed will try to avoid thinking too hard about how the administration might view this week’s decision and, in Jay Powell’s words, carry out its duties without “political fear or favor”. In fact, the timing of the next FOMC meeting, less than one week before the mid-terms, would be a solid reason to make a first policy change this week rather than waiting for a time when their decision would be more likely to be judged through a more political lens.
The issue of Credibility
Finally, there is the issue of credibility. Two months ago, in congressional testimony, Chairman Warsh asserted that the FOMC has no tolerance for persistently elevated inflation. He has also foresworn forward guidance and said that he wanted the Fed to observe market reaction to developments, direct and unfiltered.
After a slightly higher-than-expected August core CPI reading was released on Friday, the Fed funds futures market has now priced in a 92% chance of a hike in September and fully priced in another rate hike by the end of this year and a third by March 2027. In addition, in the six weeks since the last FOMC meeting, the 10-year Treasury yield has risen from 4.67% to 4.96%. The markets have clearly spoken.
And this is where the Chairman has effectively painted himself into a corner.
To paraphrase my colleague, Jordan Jackson, there is clarity in forward guidance and awkwardness in forward silence.
If the Fed wanted to maintain optionality for this week’s meeting, they could have, directly or indirectly, guided markets to understand that there is no wage inflation emanating from the labor market, that long-term inflation expectations are steady and moderate, that both growth and inflation are likely to fall in the months ahead, that the outcome of the mid-term elections could actually have a significant impact on both, and that it would be wiser to wait to the end of the year to see if policy needed to be adjusted at all.
However, in the absence of forward guidance, the market groupthink has coalesced around a rate hike this week and if the Fed doesn’t deliver one, both Chairman Warsh and the FOMC will lose serious credibility. And to this argument, in Tevye’s words, “there is no other hand”. We consequently now expect the Fed to hike.
It should be noted that, if the Fed does indeed raise rates this week, it may not look, in retrospect, like a close call. If a majority within the committee coalesces around a decision to hike, the other members may well join them to portray a more united front to the public and the President. If that is the case, the decision could be agreed to by a 10-2, 11-1 or even 12-0 vote.
Finally, after a rate hike, it is common for markets to project more hawkishness going forward. However, notwithstanding this week’s decision, we still expect both growth and inflation to cool entering 2027. If this is the case, the Fed could avoid a policy move in late October, and raise rates just once more or not at all in December. This should limit any further increase in long-term yields and allow a resumption of a longer-term dollar decline, rewarding investors for continuing to invest in core fixed income for yield, international equities for total return, and alternatives for alpha, income and diversification.