Fed rate hike preview: Expect another 75 bps, Fed has no room to soften

The US Federal Reserve is widely expected to raise interest rates by 75 bps for the third time in a row on Thursday, taking the target range to 3.00% - 3.25%.

The expectations of a 100 bps rate hike came into fruition following the hotter-than-expected August inflation print but has since been dialed back. It's still possible, but highly unlikely.

Here's the rundown for everything you need to know heading into the rate hike.

Fed to stay hawkish

US headline inflation decelerated to 8.3% year-on-year in August from 8.5% in July mostly thanks to falling energy prices.

However, the market was spooked by a hot and rather broad-based increase in core inflation, accelerating to 6.3% from 5.9% in July.

"With a monthly pickup in core CPI of 0.6% there is no room for the Fed to soften its rhetoric in the near-term," said Zurich Insurance.

Wall St tends to rally

The S&P 500 has rallied at least 1% on every Fed decision day since the tightening cycle started in March.

• 16 March +2.2%

• 4 May +3.0%

• 15 June +1.5%

• 27 July +2.6%

• Average gain: 2.3%

Still, traders are incredibly nervous heading into the decision day, with put/call premiums at levels never seen before and higher than the 2008 capitulation, according to Sentiment Trader.

In layman's terms: Investors are paying a record premium to protect their portfolio ahead of tomorrow's Fed meeting.

Source: Sentiment Trader

Inflation expectations fall

The hot August inflation print caught everybody off guard, with a knee-jerk -5.5% selloff for the Nasdaq 100. As the Bob Farrell saying goes, "when all experts agree, something else tends to happen."

Even then, the evidence of cooling inflation and slowing growth continues to mount.

"Small businesses’ price plans saw another substantial fall in August, pointing to significantly lower inflation rates in the months ahead," said Zurich analysts.

US consumer inflation expectations have also started to roll over, hitting their lowest since mid 2021. "In any event, perceptions of higher prices have calmed, particularly since June when the Federal Reserve first hiked 75 bps," said BMO economics.

Source: Bank of America

US economic growth is also on the verge of a third consecutive quarter of decline. The Atlanta Fed's GDPNow model estimates for real GDP growth in the third quarter of 2022 to be 0.3% from 0.5% last week and 2.5% earlier this month.

Source: Federal Reserve Bank of Atlanta

Fed's outlook

Perhaps what's more important than the widely expected rate hike is the Fed's updated FOMC projections for the economy and interest rates.

"Compared to the last update in June, we expect Committee members to lower their growth forecasts, raise inflation forecasts, and raise projections for the fed funds rate," said Bill Diviney, Senior Economist at ABN Amro.

"The projections are also likely to suggest that monetary policy will remain restrictive through 2023 and into 2024," he added.

This has already been reflected in the Fed funds terminal rate, which has jumped to almost 4.5% from around 3.3% in late July.

Source: Goldman Sachs