3 alternatives for today’s Federal Reserve meeting

By:
on May 3, 2023
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  • A 25bp rate hike is the most plausible scenario at today's Federal Reserve meeting
  • The key for markets is how the Fed communicates it
  • High inflation does not allow the Fed to pause yet

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The Federal Reserve meeting looms large, as another rate hike is possible despite the cracks in the US banking system. But it depends on how the Fed delivers the rate hike and the comments accompanying it.

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Some voices whisper that the Fed should already pause its tightening cycle for at least two reasons.

First, the banks are under pressure. Second, recession fears start mounting. But the Fed has a dual mandate it follows: job creation and price stability.

So here are three alternatives that the Fed has on its hands today:

  • Do nothing
  • 25bp rate hike
  • 50bp rate hike

Do nothing

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By doing nothing at today’s meeting, the Fed will let markets believe that the terminal rate has been reached. The target rate range is at 4.75%-5% already, after one of the steepest tightening cycles in history.

Recessionary fears warrant a pause. Also, the Fed may choose this option and, at the same time, deliver a hawkish rhetoric, such as further rate hikes may be appropriate depending on the upcoming data.

But the Fed already stated in the past that it wants to give the rate hikes some time to make their way through the economy. Therefore, if the Fed pauses today, then for the next six months or so, the market does not expect any change in the federal funds rate.

25bp rate hike

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The Fed may choose to hike the funds rate by 25bp. Under this scenario, the US dollar should rally initially.

It could very well be that the Fed opts for a dovish hike. Effectively, the Fed may hike by 25bp and, at the same time, signal a pause in the tightening cycle, or even the end of it, given that inflation in the United States is moderating.

As for the growth outlook, the Fed may state that a period of below-trend growth is needed in order to bring inflation down.

50bp rate hike

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This is an unlikely scenario at this meeting, but one never knows. After all, the Reserve Bank of Australia raised the interest rates this week, totally surprising financial market participants.

The Fed may argue that inflation is unacceptably high and that raising rates further is the only way to bring it down.

The Fed will likely opt for the second of the three alternatives. A 25bp rate hike looks plausible, but what the Fed says matters a lot.

Will it be a dovish hike or will the Fed keep its hawkish stance? The trick would be for the Fed to find a way to communicate policy flexibility and, at the same time, avoid markets pricing more cuts this year.

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