Fed on Track for Second Rate Hike Just Ahead of Elections

Wall Street has been on alert for more policy tightening after the Federal Reserve lifted its target rate last week for the first time in three years. But the view on timing was hazy, until yesterday.

Comments from a Fed governor and survey data on business conditions roiled the bond market on Wednesday, sending Treasury yields sharply higher and raising the odds of a hike in the Fed funds futures market.

The one-two punch started with Wednesday’s release of business survey data. The US Composite PMI Output Index, a GDP proxy, surged in September, indicating the fastest growth in more than five years. The Atlanta Fed’s GDP nowcast for the upcoming third-quarter report also points to a strong acceleration in top-line growth over the modest gain report for Q2. Good news for the economic outlook, but the bond market focused on the survey report’s price data, which continued to rise.

“Price pressures intensified in September,” S&P Global’s PMI release advised. “Average input costs measured across both goods and services surged higher, with the overall rate of inflation hitting its highest level since October 2022. The increase was widely blamed on higher fuel and transport costs, though wage pressures were also noted to have picked up in many cases.”

The rising input costs “will add further to the upward pressure on selling prices and inflation in the coming months,” wrote Chris Williamson, chief business economist at S&P Global Market Intelligence.

Shortly after the PMI was published, Fed Governor Michael Barr said “further policy adjustments are likely to be needed to ensure inflation comes down to target in a timely fashion.” Speaking at a conference in Chicago, he explained that “inflation is above our 2 percent target and not clearly trending toward target in a timely way. Moreover, risks to achieving our inflation target have increased, while risks to the labor market have receded.”

The bond market reacted by driving yields higher on Wednesday to a degree that is unusual by historical standards. The 10-year Treasury yield soared to 5.12%, reaching yet another 19-year high.

The policy-sensitive 2-year yield also rose sharply, closing at 4.90%. The nearly one-percentage-point spread over the Effective Fed Funds Rate (the volume-weighted median interest rate that commercial banks charge one another for overnight loans) reflects the market’s confidence that more policy tightening is near.

The repricing of Fed funds futures also reflects the latest shift in expectations. This market is now pricing in a 73% probability of a rate hike at the next FOMC meeting on Oct. 28.

Attention now turns to next week’s August update of the Personal Consumption Expenditures (PCE) Price Index, the Fed’s preferred inflation measure. Wall Street analysts and the Cleveland Fed’s nowcast expect that price pressures will remain above a 3% year-over-year pace, well above the central bank’s 2% target. If correct, the data will reinforce Barr’s hawkish comments favoring additional tightening.

Even if inflation data justify additional tightening, the Fed would be taking a calculated risk by raising rates on the eve of the midterm elections. The move will reinforce the central bank’s inflation-fighting credentials, but it could also expose policymakers to accusations that they are unnecessarily adding economic headwinds at a politically charged moment when Republicans are trailing in a number of polls. For a Fed that zealously guards its independence, the optics of a pre-election hike could be nearly as consequential as the policy decision itself.

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