Investors now expect Fed to raise rates to 5% next year

Investors now expect the Federal Reserve to raise interest rates to 5 per cent next year, suggesting that it will need to hammer the brakes on the economy harder than expected to tackle high inflation.

According to futures markets that track the federal fund rate, traders have fully priced in the benchmark policy rate reaching 5 per cent in May 2023, up from 4.6 per cent before the latest inflation data released late last week.

Expectations had ratcheted up after September’s consumer price index report that showed an alarming acceleration in monthly price pressures across a broad array of everyday items and services.

The larger-than-expected jump in consumer price growth all but guaranteed the Fed will yet again opt for an aggressive interest rate increase at its next policy meeting in early November and deliver a fourth-consecutive 0.75 percentage point rate rise, the odds of which have been fully priced into the market.

That would bring the federal funds rate to a new target range of 3.75 per cent to 4 per cent, significantly higher than the near-zero level registered as recently as March and closing in on the 4.6 per cent peak policy rate pencilled in by most officials in September.

The elevated inflation figures, coupled with additional signs pointing to a resilient labour market, also fanned fears that 0.75 percentage-point pace will be extended to December, with another half-point rate rise expected for February.

“Can markets push it higher? Definitely,” said Edward Al-Hussainy, a senior interest rate strategist at Columbia Threadneedle. “But we’re also at a stage where the Fed may be at risk of not being able to meet market expectations,” he added, citing financial stability concerns.

To slow the pace of its interest rate increases, Fed officials have said they need to see signs that inflation is beginning to ease on a monthly basis. To consider a pause in the historically aggressive tightening campaign, the central bank has said it needs to see substantive evidence that “core” inflation — which strips out volatile items such as food and energy — is falling back towards the longstanding 2 per cent target.

The plan, officials have said, is to lift rates to a level that actively restrains the economy and keep them there for an extended period. The higher rates rise and the longer they stay at restrictive levels, the extent of the economic pain grows, Jay Powell, the chair, warned last month.

Patrick Harker, president of the Philadelphia Fed, said on Thursday that he supports the Fed pausing after rates reach a restrictive level in order to take stock of the economy, adding that he sees fed funds “well above” 4 per cent by the end of 2022.

“After that, if we have to, we can tighten further, based on the data,” he said in a speech. “But we should let the system work itself out. And we also need to recognise that this will take time: inflation is known to shoot up like a rocket and then come down like a feather.”

On Wednesday, Neel Kashkari, president of the Minneapolis Fed and a voting member on the Federal Open Market Committee next year, also affirmed that the bar is high for the Fed to adjust course.

“If we don’t see progress in underlying inflation or core inflation, I don’t see why I would advocate stopping at 4.5 per cent, or 4.75 per cent or something like that,” he said on a panel. “We need to see actual progress in core inflation and services inflation and we are not seeing it yet.”

The move in rate expectations came after earlier this week both Canada and the UK reported that consumer prices rose more than expected in September. “This is a global story. Inflation numbers in Canada and the UK have surprised to the upside. It is the global inflation dynamic that is pushing US yield higher this week,” said Subadra Rajappa, head of US rates strategy at Société Générale.