Could the Fed raise rates by 100 basis points at its next meeting?

by Shailesh Kshatriya, Russell Investments

On the latest edition of Market Week in Review, Director of Investment Strategies, Shailesh Kshatriya, and Director of Institutional Investment Solutions, Greg Coffey, discussed the U.S. consumer price index (CPI) reading for June and how it could impact the size of the next Federal Reserve rate increase. They also chatted about the reasons behind the Bank of Canada (BoC)’s massive rate hike of 100 basis points (bps).

Is a full percentage-point rate hike in the cards for the Fed?

Coffey opened the conversation by noting that U.S. inflation exceeded consensus expectations once again in June, with consumer prices soaring by 9.1% on a year-over-year basis. The June CPI reading was even higher than May’s lofty increase of 8.6%, Kshatriya pointed out, marking the steepest rise in inflation in over 40 years.

“The key takeaway from this report is that U.S. inflation remains quite strong and is broadening out into the economy as a whole, with shelter, food and energy costs in particular continuing to surge,” he stated. Core inflation—which excludes the often-volatile food and energy sectors—did tick down slightly year-over-year, Kshatriya noted, dipping from 6.0% in May to 5.9% in June, but still topped consensus estimates of 5.7%.

Just as significantly, however, both U.S. headline and core inflation saw sizable month-over-month gains, he said—both of which came in above analysts’ expectations. “From May to June, headline CPI increased 1.3%, while core CPI rose 0.7%. This demonstrates that consumer inflation isn’t showing any signs of a substantive cool-down just yet,” Kshatriya remarked.

Recently released June data on U.S. producer prices wasn’t any more encouraging, he said, with the Bureau of Labor Statistics’ producer price index (PPI) climbing 11.3% on a year-over-year basis. Core PPI, which strips out food and energy prices, leapt by 8.2% over the same timeframe, he said. As with the CPI, in both instances, the PPI readings were above what analysts were expecting, Kshatriya noted.

The hotter-than-expected inflation numbers, combined with June’s strong employment report, has led to a shift in market pricing for the July 26-27 U.S. Federal Reserve (Fed) meeting, he said. “The debate in markets has shifted from whether the Fed will raise rates by 50 or 75 bps to whether the Fed will raise rates by 75 or 100 bps,” Kshatriya explained, noting that markets are currently assigning a 50% probability to each outcome.

While the direction that central bank officials will ultimately lean is unknown, he said that Fed Governor Christopher Waller stated on July 14 that he supports a 75-bps rate hike, but that a larger increase may be warranted if economic data released between now and the time of the July meeting comes in stronger than anticipated.

“All in all, the incoming data, particularly on retail sales and housing, will be crucial in determining the size of the next Fed rate hike—and the current uncertainty around all of this is contributing to more market volatility,” Kshatriya stated.

Bank of Canada surprises markets with 1.0% increase in overnight rate

Shifting to Canada, Kshatriya said that the nation’s central bank surprised markets by raising its policy rate a full percentage-point—or 100 bps—at the conclusion of its July 13 meeting. The jumbo rate hike—Canada’s largest since 1998—comes on the heels of a 50-bps increase in June, he said, and brings the BoC’s key borrowing rate to 2.50%. That number is essentially the midpoint of the bank’s neutral range of 2% to 3%—the range where interest rates would neither stimulate nor hinder economic growth, Kshatriya explained.

So, why did the BoC decide on a 100-bps increase in the overnight rate? Kshatriya said it’s because the central bank believes the Canadian economy, supported by a strong housing market and high commodity prices, is generating excess demand. “Perhaps most importantly, the BoC believes that consumer and business inflation expectations are at risk of becoming unanchored—and this, in bank officials’ eyes, warranted the need for a more aggressive rate hike,” he stated. Kshatriya explained that recent surveys conducted by the BoC showed that businesses and consumers expect inflation to be around a level of 5% two years from now—which is far above the central bank’s target of 2%.

He noted that at the press conference following the announcement, BoC Governor Tiff Macklem stated that the central bank’s intention is to front-load rate hikes in order to control inflation expectations. “What this means is that where the policy rate ultimately settles—let’s call it the end-destination—may not be all that different from previous central-bank guidance, but the speed at which the rate approaches this end-destination may be much quicker,” he remarked.

Kshatriya added that Macklem and other central-bank officials have indicated that the end-destination for the overnight rate is probably near the upper-end of the neutral range of 2% to 3%, or possibly a little bit higher. “This would suggest a policy rate of 3.25% to 3.50%, which in my opinion seems conceivable at this point,” he stated.

With Canadian housing and household-debt levels among the most inflated in the world, there’s a risk that the BoC overshoots its target, which Kshatriya said would increase recessionary risks. “Ultimately, however, the central bank sees the lack of price stability as a greater risk to the economy right now, and wants to ensure that inflation expectations stay contained,” he concluded.

 

 

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