TONE is everything for US Federal Reserve watchers and global markets this week.

The US central bank is likely to leave interest rates unchanged at its latest policy meeting that ends on Wednesday, but the way it relays the message will be the critical factor for how the stock market reacts.

It’s hard to overstate the pivotal nature of Fed chairman Jerome Powell’s mood to global financial markets. The Fed “pivoted” last December when Powell dropped his stern warnings of a long war against inflation in favour of soothing reassurances about the end of inflation and the likelihood of averting a recession.

That kicked off one of the strongest turn-of-year rallies on the broad stock market in history. The S&P 500 is up almost 19 per cent since Nov 1, chiefly because of Powell’s change in demeanour.

While the Fed is almost certain to stay pat with rates in their current range between 5.25 per cent and 5.5 per cent, there’s a chance that the statement or, more likely, Powell’s post-meeting press conference, will cause a dramatic stock swing one way or the other.

Strategists say there are three possible outcomes, in this order of likelihood: the Fed could cause a panicky sell-off if officials push back against expectations of a rate cut in the near term; the Fed could cause a major rally if it hints that a rate cut is likely at its next meeting in March; or the Fed could cause a garden variety sell-off if it echoes its December statement and hints at rate cuts to come without any guidance on when that might happen.

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Quincy Krosby, chief global strategist at brokerage LPL Financial, anticipates a pivot back to more neutral language from Powell. She said that December’s meeting was followed by what sounded like damage control from a series of Fed officials, all of whom seemed intent on walking back market misinterpretations of Powell’s comments.

“That’s been orchestrated, because both the hawks and doves have delivered the same message to the market. And that is yes, we see rate cuts coming, but we want to be certain, we want to be prudent, we want to make sure that inflation continues moving in the right direction,” she added.

Recent data suggests that the Fed still has reason to believe in the soft landing scenario that gave Powell such a peppy tone in December. 

The personal consumption expenditures index – the central bank’s preferred inflation gauge – ticked up in December to 2.9 per cent, but remained within spitting distance of the Fed’s comfort level of 2 per cent annual inflation. For weekly grocery shopping and in home heating, in particular, the sense of ever-mounting bills seems to have eased for most Americans.

The Fed may fear a “flare-up in inflation” following fresh data last week that showed surprisingly strong consumer spending bolstering the US economy in the fourth quarter.

The risk of another wave of inflation is unequivocally rising. Most economists argue that supply-chain dysfunction because of uneven Covid-19 reopenings played a major role in stirring up inflation during 2021 and 2022.

That’s once again become a major risk, with carmakers Tesla and Volvo, and global miner BHP Billiton among those warning that Houthi rebel violence in the Red Sea has forced adjustments to their supply chains. Oil futures are also on the rise, hovering at around US$75 a barrel.

One reason for Powell to push back and revert to his pre-December hawkish self would be if he fears that his dovish tone caused outlandish speculation on tech stocks in the weeks since his last statement.

He has observed in the past that investor interpretations of Fed policy can, counter-intuitively, become an independent source of inflation. That’s because Wall Street will go all-in on deal activity, stock and real-estate speculation if firms become confident that rates are on a downward path.

The US housing market was one source of inflation in the last couple of years, partly because red-hot demand for the kind of construction and refurbishment that accompanies an expanding housing market caused raw materials prices to rise sharply.

For this reason alone, Powell could present a slightly more hawkish face this week, and refuse to give any hints on when rate cuts are planned, or even hint that those plans are on hold.

The most likely outcome, however, is that Powell will curb his enthusiasm ever so slightly in his press conference on Wednesday, leaving the door open for cuts but speaking less sunnily about the inflation and economic-growth outlooks.

“Our base case is for 150 basis points of rate cuts this year, starting in May,” said Carl Riccadonna, chief US economist at brokerage BNP Paribas, in a note to clients.

“Though we cannot rule out a March move if data warrants (such as a stall in hiring or other activity data), our recent upgrade to economic growth in the first half of 2024 raises the alternative risk that cuts are delayed or diminished.”