Investors expect that the Federal Reserve will raise interest rates on Wednesday in a bid to curb inflation, with bets in financial markets pointing to a 90 percent likelihood of a quarter-point increase.
But bond investors are still on edge, mindful of a new, less predictable leader of the central bank in Kevin M. Warsh. If the Fed doesn’t lift rates, then investors will probably question the central bank’s commitment to containing inflation, prompting them to increase their own forecasts for price pressure and injecting new turmoil into the government bond market.
Already, the 30-year Treasury yield is at its highest level in nearly two decades and the 10-year yield is flirting with a similar milestone. These yields provide the bedrock of the global financial system, used as a benchmark to establish borrowing costs for companies seeking loans and consumers taking out mortgages.
“If the Fed has credibility on policy then you see inflation expectations remain contained,” said Subadra Rajappa, an interest rate strategist at Societe Generale. “If they don’t respond to inflation, and when they can’t control inflation, that is when you are going to start to see more wild price action.”
Inflation pressure has been building as a result of America’s attack on Iran at the end of February and the sharp rise in oil prices that resulted. But until recently, that inflation pressure has mostly remained a short-term worry, one that bond investors believe can be solved over the next few years, precisely because they expect the Fed to act.
Investors with a longer-term view have instead focused their worries on tariffs, tax cuts, government spending and, especially, on the soaring spending (and borrowing) from artificial intelligence companies. The expectation that higher inflation persists for the next 10 or even 30 years has not been a major concern, based on market prices.
The 10-year break-even inflation rate, a market measure of investors’ inflation expectations over the next decade, stands at around 2.4 percent, modestly above the Fed’s long-term target of 2 percent. That measure fell to a low for the year of 2.2 percent in June, when the war with Iran appeared to be winding down.
“If they don’t hike, the risk is that inflation expectations, particularly at the long end, start to rise,” said Brendan Murphy, head of fixed income for North America at Insight Investment.
And there is the potential for a longer lasting impact for Fed officials when it comes to fighting inflation. “The market starts to think they are not credible,” he added.
The tension around Wednesday’s meeting reflects a sharp shift in expectations under President Trump, who has repeatedly said he wants to see interest rates move lower, handpicking Mr. Warsh to do just that.
The day before Donald Trump attacked Iran at the end of February, investors expected the Federal Reserve to lower interest rates by a quarter of a percentage point twice through the end of the year. Now they expect the central bank to raise them as many as four times through next year.
When Mr. Warsh took helm of the Fed in May, he committed to a new communication style that limited guidance for investors about what the Fed might do next. As part of this approach, Mr. Warsh initially refused to commit to lifting interest rates in response to growing inflation pressure, amping angst among bond investors left unsure of how the central bank would now respond to rising inflation.
Then in August, investors interpreted a speech by Mr. Warsh to be a signal that if inflation pressures remained, he would raise interest rates. Data released this month showed prices throughout the economy continued to rise in August, and investors are now looking for Mr. Warsh to make good on his perceived commitment.
George Goncalves, an interest rate strategist at MUFG Americas, worries that interest rates have already moved too far, too quickly, and that the result could slow the economy more in the coming months than is currently expected. Still, he expects the Fed to elevate interest rates to maintain its credibility.
“You have to now hike,” he said. “You can’t really not hike.”
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