July Will Probably Mark Peak Fed Hawkishness. Betting on What’s Next Is Trickier.

Fed Chairman Jerome Powell, shown testifying at a House panel hearing last month, will answer questions about the economy and monetary policy Wednesday at 2:30 p.m. Brendan Smialowski/AFP/Getty Images

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The Federal Reserve will probably raise interest rates by another three-quarters of a percentage point when its July meeting ends Wednesday afternoon. Betting on the path of policy beyond that is getting trickier. 

First, on this week’s decision. For all the discussion in recent weeks of the possibility of a full-point rate hike in July, the chances of that outcome are low—and probably even lower than the 25% chance reflected in CME data. That is despite the new 40-year high in consumer price inflation, and on account of one key data point. Investors will remember that it was a pop in the University of Michigan’s longer-term inflation expectations index for June that spooked central bankers at the last minute into a supersized hike for June. The 0.75-percentage-point increase was the biggest since the mid-1990s. But that gauge was later revised lower, and then the recently released July figure fell to the lowest level in about a year.

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Still, inflation expectations remain elevated compared with the Fed’s 2% target. And because the consumer-price index again defied peak-inflation hopes and jumped 9.1% in June from a year earlier, the Fed isn’t going to do a smaller half-point hike this time. But given some price declines since the last CPI report, such as across commodities, and because of mounting signs of economic weakening, July will probably mark peak hawkishness.

But how quickly a hawkish Fed turns dovish is the real question. Investors and many Wall Street economists and strategists have been anticipating a quick flip from rate hikes to rate cuts by early next year. Economists at Goldman Sachs, for example, say the Fed will probably hike by 0.5% in September and then another 0.25% in each of the November and December meetings, bringing the policy rate to a peak of 3.25-3.5%. CME data shows traders expect the Fed to top out at 3.5-3.75%, with rate cuts starting in the first quarter of 2023. There are more than 80 basis points, or 0.8 percentage point, of cuts priced in for 2023 and another 25 basis points of cuts priced in for 2024, notes Roberto Perli, head of global policy at Piper Sandler.

Not everyone, Perli included, thinks the Fed will so easily choose growth over inflation and begin slashing rates only a year after starting to raise them.

“In theory, that makes sense given that a recession is probably coming,” Perli says of current rate-cut expectations. He notes that historically, the Fed has started cutting rates when the unemployment rate was, on average, about 0.3% higher than the low in the previous 12 months and jobless claims were 40,000 above the low of the previous 12 months.

Said another way, the Fed usually hasn’t waited very long to start cutting. The unemployment rate is right now near a record low, but given the recession that’s probably coming (and maybe already here) the jobless rate might be several tenths of a percent higher by early 2023. Jobless claims, meanwhile, are rising and have increased by 65,000 from the late-March lows. By the latter metric, Perli says the Fed should already be cutting rates. By the former, they wouldn’t be yet as the unemployment rate is near a record low. But Perli says it is plausible that the jobless rate rises by a few tenths by early next year.

But Perli says markets are underappreciating what is different this time. First and most obviously, inflation is much higher than at any time in the modern Fed era. Second, he says, the labor market is much tighter than normal, to the point where the Fed probably welcomes some additional slack—a euphemism for higher unemployment. Thus, says Perli, markets are too optimistic in expecting rate cuts so soon. That isn’t to say the Fed would ignore the effects of recession, but Perli says the Fed’s response to a recession that is accompanied by high inflation and a tight labor market will be much more delayed and slower than in the past. 

Deutsche Bank strategist Tim Wessel goes a step further in warning that investors are too sanguine. A recent study he conducted found that year-ahead market pricing has underestimated how tight Fed policy would eventually become by an average of 85 basis points,  and a median of 60 basis points, when core inflation was above 4%. Applying Wessel’s conclusion to current rate expectations means the so-called terminal rate will be above 4%. For context, 2.5% has been considered the neutral policy rate, where interest rates neither speed up or constrain economic activity. Last tightening cycle, which ended in December 2018, the Fed topped out with rates in a range of 2.25-2.5%. 

There is a lot of time between now and early next year, when markets expect the Fed to start cutting rates. For now, both camps—the one expecting a quick policy reversal and the one warning investors are too confident about early 2023 rate cuts—will have plenty of fodder. Comments out of Fed Chairman Jerome Powell during his press conference Wednesday afternoon aren’t going to settle the debate as Powell will at once reiterate his commitment to fighting inflation while acknowledging a cooling economy.

Later this week, investors will probably see a second consecutive negative print for gross domestic product, which only will underpin economic growth concerns. A day later, the personal consumption expenditure price index—the Fed’s favorite inflation gauge, is expected to show a new pickup from June. The pair of data together highlight the tough road ahead for the Fed, and for investors trying to predict when rate hikes will turn into rate cuts.

Write to Lisa Beilfuss at lisa.beilfuss@barrons.com