The Fed rate hike: what happens now?

The dust has settled on tonight’s Fed meeting and the market reaction is clear: the Fed’s signal that there could be a series of rate hikes has spooked financial markets. Bonds sold off at the short end of the Treasury curve and US stocks also fell, led by the Dow Jones Industrial Average, which slipped more than 1% on Wednesday night.

Early signs from US futures suggest that the sell off will deepen on Thursday, as the market digests a new rate hiking cycle from the Fed. The issue for Kevin Warsh and the Fed members is price stability. All 12 voting members of the Fed voted to hike rates, which suggests a new-found unity around tighter monetary policy. This makes more hikes likely as the Fed attempts to reach its 2% inflation target.

It’s not one-and-done

Chairman Warsh justified the hike on the back of hot inflation, a strong economy and recent signs that the labour market remains robust. Although the Fed does not give forward guidance, it’s now reasonable to assume that if these conditions are met then another rate hike could be forthcoming. In the aftermath of today’s meeting the Fed Fund Futures market is pricing in a roughly even chance of a rate hike in October and in December.

After the stronger than expected retail sales data for August, which suggests that the US consumer is running on full cylinders, the Atlanta Fed’s GDPNow tool is predicting GDP is expanding at a 5.1% annual rate for Q3. With growth this strong, and inflation pressures building, an interest rate hike is a ‘no brainer’, in the words of Christine Lagarde.

A hawkish tilt of the Dot Plot

There was a hawkish shift in the Dot Plot, with 16 out of 18 Fed officials seeing at least one more hike this year, four members see the potential for two further hikes this year. However, there is currently no expectation that rates will rise in 2027 or 2028 included in the Dot Plot, and the terminal rate, or peak in rates, has risen to 4% – 4.25%, from 3.75% at the Fed’s previous meeting.

The market is likely to price in even more hikes since the Federal Reserve’s economic forecasts do not see inflation returning to target until 2029. Core PCE, the Fed’s preferred inflation measure, was also revised up to 3.7% for this year, although the index is expected to moderate to 2.3% for headline inflation next year.

The Fed rarely embarks on a one-off rate hike, and the evidence is not there for a one-and-done rate hike approach. The Fed has signalled that they will do as much monetary tightening as necessary to bring inflation back to target.

The Warsh test

Warsh has set himself a test. Rather than sit back and let a foreign energy price spike lift inflation and inflation expectations in the US economy, he will act now to stop an energy price spike from causing second or third round economic damage. This is a lofty task, especially since energy prices are likely to stay elevated for some time.

Kevin Warsh staked his credibility at this meeting. Not only is he coming for the 2% inflation target, but he put his money where his mouth is. Warsh has been raising concerns about inflation repeatedly this summer, now he has finally done something about it. Added to this, the Fed has reasserted its independence, which is also good news for the bond market in the long term, and we think that today’s actions could stabilise long-end US Treasury yields.

Trump calls for 1% interest rates

Trump did call for rates to be cut to 1% immediately, but he did not lambast Warsh, and so far has not threatened him with legal action. If Trump wants lower interest rates, then he should sit down with Iran and hash out a ceasefire.

Analysts and investment banks are coalescing around a further rate hike in December, rather than October, and a pause before hiking again would seem sensible. While there are currently just over 1 more hike expected by the Fed at this stage, Warsh and co’s commitment to the 2% inflation target seems resolute, and may require further action.

The market view

From a market perspective, stocks were lower, although the Nasdaq outperformed and managed to eke out a small gain. The market assumes that cash-rich tech companies can weather this storm better than households and consumers. The weakest sector in the US stock market was energy on Wednesday, after oil prices fell. However, there were broad declines in consumer discretionary stocks, and for some financial stocks including US Bancorp and Robin Hood. We expect this theme to play out, with indices struggling to rally on a broad basis for as long as the upside risks to inflation remain front and centre.

The dollar also surged, and the gold price fell to its lowest level since August. USD/JPY will be in focus after this pair jumped more than 100 points in the aftermath of the Fed press conference. USD/JPY is now above 156.00. We will need to see if the BOJ can stem yen weakness with an expected rate hike of its own on Friday.