Fed rate decision this week: why a pause could shock markets more than a hike 

The Federal Reserve could deliver its first interest-rate hike since 2023 this week, but the bigger shock for markets may now be if it does nothing.

Traders are pricing an 87% chance that policymakers will raise rates by 25 basis points on Wednesday after hotter August inflation and higher oil prices.

Goldman Sachs and JPMorgan have both moved into the hike camp.

That leaves investors facing an unusual asymmetry, as a hike is largely priced in, while a pause could revive doubts about the Fed’s inflation credibility and push long-term Treasury yields higher.

Wall Street has moved from debating a hike to expecting one

As recently as before last week’s inflation data, markets were less convinced. The probability of a September hike was around 70% before climbing to 87% after stronger CPI and PPI readings.

August headline CPI rose 0.4% from July and 3.4% from a year earlier. Core CPI increased 0.3% on the month, above the 0.2% consensus, while annual core inflation stood at 2.4%.

Goldman abandoned its previous hold call and now expects a quarter-point increase. JPMorgan expects hikes in both September and December.

Goldman economist David Mericle told the Financial Times that policymakers would “worry about the potential market reaction to not delivering a hike that recent Fed communication has guided the market to now almost fully price.”

Investors have adjusted to higher short-term rates. A hike could still pressure rate-sensitive assets, but it would confirm the policy path markets now expect.

Doing nothing has become the more disruptive trade for financial markets.

A pause could push long-term yields higher

Normally, leaving rates unchanged would be expected to support bonds. This meeting could produce the opposite reaction.

The 10-year Treasury yield is hovering near 5%, after reaching 4.98% last week, as investors grapple with sticky inflation, expensive oil, heavy government borrowing and concerns about the US fiscal outlook.

Goldman Sachs trader Rich Privorotsky told MarketWatch that the danger of not hiking is that the Fed “may lose control of the back end of the curve” if investors conclude policymakers are not serious enough about inflation.

That matters for equities, as a rise in long-term yields increases discount rates, makes Treasury returns more competitive with stocks and places particular pressure on expensive technology and growth shares.

A pause could therefore look dovish at the front end while tightening financial conditions further out the curve.

That is what makes Wednesday unusual: the apparently easier policy choice could trigger the harsher market reaction.

The bigger issue is Fed credibility

The debate ultimately goes beyond another 25 basis points.

Headline inflation remains at 3.4%, core inflation surprised to the upside, and Brent crude remains above $100 as Middle East supply risks keep energy prices elevated.

The federal funds target range stands at 3.5% to 3.75%.

Chris Zaccarelli, chief investment officer at Northlight Asset Management, said it was difficult to see how policymakers could justify standing still.

“There’s no guarantee that the Fed will hike next week, but it’s hard to see how the central bank can justify leaving rates on hold,” he said, according to MarketWatch.

A well-communicated pause could still work if the Fed signals that future tightening remains available.

But hesitation without a clear explanation could raise doubts about whether policymakers are prepared to tolerate inflation above target.