Investors now expect Fed to raise rates to 5% next year

Investors are now expecting the US Federal Reserve to hike interest rates to 5 percent next year, suggesting it may need to slow down the economy more than expected to combat high inflation.

According to futures markets that track the Federal Fund rate, traders have fully priced in the benchmark interest rate, which hit 5 percent in May 2023, up from 4.6 percent before the latest inflation data released late last week.

Expectations had risen after September’s CPI report, which showed an alarming acceleration in monthly price pressures on a wide range of essential items and services.

The larger-than-expected pick-up in CPI growth has all but guaranteed that the Fed will again opt for an aggressive rate hike at its next monetary policy meeting in early November, delivering a fourth straight 0.75pp rate hike, increasing the likelihood of it fully in the US market are priced in.

That would bring the federal funds rate to a new target range of 3.75 percent to 4 percent, well above the near-zero level recorded as recently as March and closer to the 4.6 percent peak interest rate targeted by most officials in September.

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The elevated inflation numbers, coupled with additional signs pointing to a resilient labor market, also fueled fears that the pace will be extended by 0.75 percentage point through December, with another half-point rate hike expected in February.

“Can the markets push it higher? Absolutely,” said Edward Al-Hussainy, a senior rates strategist at Columbia Threadneedle. “But we are also at a stage where the Fed is at risk of not being able to meet market expectations,” he added, citing financial stability concerns.

To slow the pace of rate hikes, Fed officials have said they need to see signs inflation is slowing on a monthly basis. To consider a pause in the historically aggressive tightening campaign, the central bank has said it needs hard evidence that “core” inflation – which excludes volatile elements like food and energy – is falling back to the long-term target of 2 percent.

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The plan, officials said, is to raise interest rates to levels that actively slow the economy and hold them there for an extended period of time. The higher interest rates rise and the longer they stay at restrictive levels, the worse the economic pain will be, the chairman, Jay Powell, warned last month.

Patrick Harker, President of the Philadelphia Fed, said Thursday that he supports the Fed’s pause after rates hit hawkish levels to take stock of the economy, adding that he would call on the Fed’s funds to end ” well over” 4 percent see 2022.

“After that, if need be, we can further streamline based on the data,” he said in a speech. “But we should let the system work itself out. And we also have to recognize that this will take time: inflation is known to shoot up like a rocket and then come down like a feather.”

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Also on Wednesday, Minneapolis Fed President Neel Kashkari and next year’s voting member of the Federal Open Market Committee reiterated that the bar is set high for the Fed to adjust course.

“If we don’t see any progress on underlying inflation or core inflation, I don’t see why I would advocate stopping at 4.5 percent or 4.75 percent or something,” he told a panel. “We need to see actual progress in core inflation and services inflation, and we’re not seeing it yet.”

Interest rate expectations moved after earlier this week both Canada and the UK reported that consumer prices rose more than expected in September. “This is a global story. Inflation figures in Canada and Great Britain surprised on the upside. It’s global inflation dynamics that’s driving US yields higher this week,” said Subadra Rajappa, head of US rates strategy at Société Générale.

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