Investors are pricing in more aggressive interest rate hikes by the Federal Reserve after Friday’s hotter-than-expected inflation report.
After anticipating a half percentage point rate hike this week, investors are now thinking the Fed might end up conducting a 75- or even 100-basis-point hike in future meetings, a prospect that is causing the stock market to plummet.
Many economists thought that inflation had peaked when it declined to an 8.3% annual rate in April. But then, Friday’s consumer price index report showed inflation rising again to 8.6%, the highest since 1981, leading investors to think the Fed might take extraordinary steps to lower price pressures.
A week ago, investors placed the likelihood of a half-point rate hike occurring at about 97%, according to CME Group’s FedWatch tool, which calculates the probability using Fed fund futures contract prices. After Friday’s report, investors are now pegging those odds at just over 68% and pricing in a 31.3% chance of a 75-basis-point hike.
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If the Fed decides to jack up rates by 75 basis points this week or at its meeting in July, it would mark the first time such an aggressive tack has been taken since 1994. Some banks are already betting that the Federal Open Market Committee, led by Fed Chairman Jerome Powell, will take that plunge.
“The U.S. central bank now has good reason to surprise markets by hiking more aggressively than expected in June,” Barclays economists said in a Friday note following the CPI report’s release. “We realize it is a close call and that it could play out in either June or July. But we are changing our forecast to call for a 75-basis-point hike on June 15.”
Powell himself has tried to give the markets as much lead time as possible in an attempt to avoid shocking investors and causing them to panic.
He and others have consistently signaled the degree of rate hikes prior to FOMC meetings, although this latest report came as a bit of a surprise and occurred during the Fed’s blackout period, which occurs about two weeks before FOMC meetings and limits what participants and staff can say publicly or in interviews.
During an interview with the Wall Street Journal in May, Powell hinted that the Fed could ratchet up its efforts to rein in inflation should it prove to be persistently sticky in the face of tightening monetary policy.
“What we need to see is clear and convincing evidence that inflation pressures are abating and inflation is coming down — and if we don’t see that, then we’ll have to consider moving more aggressively,” the Fed chairman said.
Friday’s bad inflation report was buffered by another much-worse-than-expected report that found consumer sentiment sunk to record lows as consumers expressed anxiety over inflation and what is to come for the economy.
The University of Michigan Consumer Sentiment Index plunged to 50.2 in June, down from 58.4 in May, according to preliminary numbers.
Economists at Jefferies also revised up their expectations of the Fed’s rate-hiking cycle. They now expect a 75-basis-point hike following this week’s meeting “as inflation expectations begin to de-anchor.”
Jefferies economists Aneta Markowska and Thomas Simons said that the CPI numbers and the consumer sentiment report “are game changers that will force the Fed to switch to a higher gear and front-load policy tightening.”
Steven Englander, global head of G10 FX research at Standard Chartered Bank, even raised the possibility of the Fed hiking interest rates by a full percentage point.
Englander said that the Fed might try to have a “Volcker moment,” a reference to former Fed Chairman Paul Volcker, who is known for having hiked the federal funds rate to extreme levels to tamp down price increases during the Great Inflation, the last time inflation was this high.
“The Fed’s trying to erase any perception that they’re behind the curve,” Englander told Bloomberg. “Fifty was the big round number six months ago. Meanwhile, 75 is a very middling type of hike. So, the Fed might say: ‘Look, if we want to show commitment, let’s just do 100.’”
The stock market has been in quick retreat as investors eye the uncertainty surrounding the Fed meeting and painful inflation.
The S&P 500 fell nearly 3.9% at close, entering a bear market on Monday. A bear market is when an index drops to below 20% from a recent high. The Dow Jones Industrial Index lost more than 875 points, and the Nasdaq shed about 4.7% of its value.
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There are fears that the Fed hiking rates so quickly will knock the economy into a recession.
A recent survey, conducted by the Financial Times in partnership with the University of Chicago’s Booth School of Business, found that 68% of the 49 economists surveyed said the most likely timing of a recession is sometime next year.
