Fed will leave rates alone, but changes in Powell’s statement could be just as scary

STOCK and bond investors are celebrating the US Federal Reserve’s decision to stop raising interest rates and declare victory over inflation. Unfortunately, somebody forgot to tell the higher-ups at the Fed.

This Wednesday (Sep 20), the Fed will likely leave rates unchanged at a 22-year high of 5.25 per cent to 5.5 per cent, pausing for the second time in its last three meetings. Still, chair Jerome Powell could give financial markets a nasty surprise if his rhetoric in his usual post-meeting statement suggests more rate hikes could be on the way.

“The Fed will likely be on hold at their next decision on Wednesday, but the next change in policy is still more likely a hike than a cut,” warned Bill Adams, chief economist at brokerage Comerica Bank.

Most investors have positioned themselves for an end to rate hikes. A subtle hint in the Fed’s last statement in August – the promise to proceed with “caution” on interest rates – was interpreted by the vast majority of stock investors as the tacit signal that the rate-hike cycle is coming to a close.

After all, the bulls said, the Fed could not definitively say the rate increases were finished, for fear of setting off a jubilant wave of speculation. 

The belief that interest rates are at or very near their peak is one of the only reasons to buy into the 2023 stock market rally. Earnings growth has been tepid, at best, and the best anyone can say about the economy is that a multiyear expansion is ending with a “soft landing”.

This is the belief that, if the Fed stops now, it will have quelled inflation without bringing on a recession. Artificial intelligence may be the toast of Wall Street, but the party on the stock market, which has given the S&P 500 an 18 per cent return for the year to date, is all about the end of rate hikes.

Mike Wilson, the chief equity strategist at brokerage Morgan Stanley, has predicted the stock bulls will eventually receive what amount to a slap in the face from the Fed, as Powell feels compelled to remind them that the spectre of inflation remains at large.

Powell has played the role of party pooper before. For the duration of 2022, he doused every nascent stock-market rally with his hawkish warnings that the central bank was committed to vanquishing inflation, no matter what the collateral economic damage. Powell may feel it’s time to give the stock bulls another stern telling-off.

After all, consumer inflation accelerated in August, according to recent data, rising 0.8 per cent from a month earlier. And that’s before the latest surge in energy prices.

The situation with the Ukraine war is much as it was when the Fed started raising rates in 2022. The world’s bread basket – between them, Russia and Ukraine produce more than one-quarter of global wheat exports – is still riven by war. In reprisal for Western military aid in Ukraine, Russian President Vladimir Putin and his allies in Saudi Arabia are choking off oil supplies.

The global benchmark Brent futures contract for crude oil has risen 30 per cent since June and looks likely to test the psychological barrier of US$100 a barrel in the near term. The increases in petrol and diesel prices have been even more drastic, reflecting limited refinery capacity.

In short, inflation is not going away. Supply chains may have finally disentangled themselves from the pandemic but many economists anticipate inflation will come back with a vengeance.

“What’s causing confusion is that many people are saying that they’re done raising rates,” said JJ Kinahan, chief executive of IG North America and president of its brokerage tastytrade.

Powell, however, has promised no such thing. 

Said Kinahan: “To give him credit, if you look at his messages, they’re pretty consistent. We’ve got to see will there be any change in wording that’s very tough to handicap going into the meeting.”

The big fear, he added, is that consumers will slow their holiday shopping activity because petrol has become such a big expense.

“Given further increases in crude oil prices and unseasonably warm weather, energy prices could continue to put upward pressure on headline CPI in the near term,” said economists at brokerage Bank of America Global Research in a note to clients.

The Fed will almost certainly leave rates unchanged; but the only way to avoid a shock to the stock market might be leaving its statement unchanged, too.

Should Powell acknowledge the threats of rising oil prices and inflationary labour disputes in Detroit and beyond, the stock-market bulls may be in for a rough ride.