How likely is the Federal Reserve to hike the federal funds rate when its monetary policy committee ends a two-day meeting next Wednesday? Just a few months ago, the question would have seemed absurd: all the talk was about rate cuts in 2026.
But then the war in Iran and the wider Middle East came along, unleashing a new round of inflation. And the Fed's main tool when it wants to fix inflation is to hike general interest rates.
What Markets Think May Happen
So far, markets think a hike next week remains unlikely. The CME FedWatch tool, which is based on investors buying Fed rate futures to hedge against movements ("30-Day Fed Funds futures prices"), puts the chances of an increase on Jul. 29 at 14.4%.
However, the same tool reckons the odds of the Fed raising the federal funds rate at its following meeting, on Sep. 16, are 62%, including an 8% probability of a large, 50-basis-point (half a percentage point or 0.50%) hike. The Fed usually moves rates in 25-basis-point increments.
The End of Forward Guidance
It's worth viewing the FedWatch tool's findings with a little more skepticism than normal. Before this coming meeting, the Fed has issued forward guidance that has clearly signaled its intentions over rate policy, meaning that meetings rarely produced surprises.
However, new Fed Chair Kevin Warsh has largely scrapped forward guidance. And that increases the possibility of rate announcements causing market shocks and volatility if they're unexpected.
Still, some senior Fed officials have recently shared their opinions, including Warsh himself. According to TheStreet, he managed to discuss rate hikes in Congressional testimony without using the term "rate hikes."
"We have the tools to do it," Warsh told legislators. "Over the coming period, I’m going to ask our colleagues to have a good family fight about the extent and timing in which we would need to deploy those."
But Inflation Is Falling!
On July 14, the official consumer price index (CPI) showed consumer prices "decreased 0.4% on a seasonally adjusted basis in June after rising 0.5% in May." What? Rate hikes are intended to rein in inflation, so why even think about raising rates while prices haven't just stopped rising but are actually falling?
It's because there's plenty of evidence that June will prove an outlier, and that prices will be appreciably higher again in July and in other coming months.
On Monday morning, the AAA announced that the average price nationwide for a gallon of regular gas was $4.0030. A week earlier, it had been $3.8720.
Diesel, upon which the country (and the world) relies for the overland transportation of goods and raw materials, is even more costly. It stood at $5.1080 per gallon that morning, up from $4.8750 a week earlier.
When diesel prices rise, transportation costs do, too, and that eventually feeds through as higher consumer prices.
Meanwhile, other price increases are almost certainly in the pipeline. For example, the supply of fertilizer and ingredients for the manufacture of fertilizers was badly hit when the Strait of Hormuz closed. That raised farmers' input costs, something that's likely to be reflected in consumer prices after future harvests.
An Oil Crisis in Prospect?
Governments around the world have been protecting consumers from the worst effects of rising oil prices (no, really!) by raiding their strategic reserves. The extra supply from those sources reduced the amount by which gas and diesel prices increased.
Last Wednesday, the International Monetary Fund (IMF) wrote, "The estimated market deficit of about 4.0 million barrels a day in March–May was met almost entirely by drawing down global stocks, including commercial inventories in China and strategic reserves."
Last Friday, in an email, the IMF painted a grim picture:
"Higher prices curbed demand, especially in Asia, production outside the Gulf increased more than expected, and governments and companies drew down inventories to fill the gap. Together, these shock absorbers helped the global economy weather a supply disruption that exceeded those seen during several previous oil crises.
"But as tensions flare again in the Middle East, much of that room to maneuver has been used up. Spare capacity has been deployed, demand has already adjusted, and inventories [strategic and other reserves] have been drawn down. Unless stocks are rebuilt and energy supplies become more diversified, the world could be more exposed when the next shock arrives."
In other words, unless the Strait of Hormuz reopens quickly, we ain't seen nothing yet.
So, How Likely Is the Fed to Hike Rates Next Week?
All the members of the Fed's rate-setting body — formally known as the Federal Open Market Committee (FOMC) — know that an oil shock and a subsequent spike in inflation are real possibilities. And some will wish to anticipate that by hiking the federal funds rate next Wednesday.
The question is how many other FOMC members will go along with those hawks, and how many will side with the doves, who'd prefer to wait at least until their September meeting to make a move. There's no way to know for sure.
However, on balance, we suspect the investors monitored by the CME FedWatch tool (who put their money where their mouths are) are likely to be proved right. Warsh, who was appointed with the expectation that he would cut interest rates, would probably prefer not to hike them at only his second meeting.
Do Fed Rates Matter to Mortgage Rates?
There's a big debate among observers of mortgage rates as to whether those rates are affected by Fed cuts and hikes. And there have certainly been examples of days on which a Fed announcement has been followed by mortgage rates heading in the opposite direction.
However, we suspect that's because the Fed has made its FOMC meetings so transparent, and has signaled with near certainty what will be announced. That may change now that forward guidance is out, and we shouldn't be surprised if a shock FOMC rise pushes mortgage rates higher.
But even if there isn't a direct link between FOMC announcements and mortgage rates, there is a different sort of relationship. That's because the interests of the investors who trade in mortgage-backed securities (MBSs, the type of bond that dictates mortgage rates) and the Fed coincide.
Investors who buy any sort of bond purchase a fixed income. And anyone with a fixed income loathes and despises inflation because it eats into the value of their money. If they get a 4% yield on a bond but inflation is running at 5%, they're actually losing money on their investment.
So, whether or not the Fed influences mortgage rates, inflation does. And the outcome is the same.
