Uncertainty reigns as Fed considers interest rate hike

By Lindsay Dunsmuir

(Reuters) -Traders and economists remain split on whether the Federal Reserve will raise its benchmark policy rate on Wednesday, as more actions by the world's major central banks to stem banking strains and the fallout from the takeover of Credit Suisse kept markets on edge.

The U.S. central bank will begin its two-day policy meeting on Tuesday as policymakers consider whether still too-hot inflation merits an interest rate hike or whether turmoil in financial markets outstrips those concerns. The Fed's current target range is 4.5%-4.75%.

"I don't think the Fed has any good options here," said Tim Duy, chief U.S. economist at SGH Macro Advisors. "The risk is allowing inflation to become even more embedded versus the risk of aggravating a broader banking crisis."

Prices of Fed funds futures reflected a roughly 70% probability of a quarter-percentage point rate hike on Monday versus about a 30% chance of no change, a slight firming in expectations compared to the end of last week.

Market pricing has swung wildly over the past 10 days with investors going from expecting a bigger half-point rate rise before banking stresses emerged to at one point seeing rates unchanged. Among economists, those who predict a quarter-point rise do so without ruling out the potential for a pause.

The Fed usually likes to telegraph the expected outcome of its policy meetings in order not to unsettle financial markets but the fast pace of events in the past 10 days, in which two U.S. regional banks collapsed and Credit Suisse was rescued by larger rival UBS at the weekend, has upended those norms.

On Sunday, the Fed, as part of a coordinated action, offered daily currency swaps to banks in Canada, Britain, Japan, Switzerland and the euro zone in order to ease funding stress in global markets, although banks borrowed only token amounts on Monday. The Fed also has already created an emergency liquidity backstop for U.S. banks.

The tumult has occurred during the central bank's premeeting blackout period that prevents officials from offering public clarity on their assessment of the situation.

TO HIKE OR NOT TO HIKE?

"Barring a catastrophic collapse of the banking sector between today and Wednesday -- one that reverberates globally -- they will be focused on developments in the economy, which currently supports more policy tightening," said Rubeela Farooqi, chief U.S. economist at High Frequency Economics, who forecasts a quarter percentage point rate increase.

She pointed to a string of recent economic data, including a key inflation report last week, that suggest inflationary pressures are far from tamed, and expects the Fed this week to lift its median projection for the funds rate at year-end to 5.4% from 5.1% at December's meeting.

Inflation, while off its highs, is still running at 5.4% by the Fed's preferred measures, far above the 2% target rate.

The Fed has also been shown a template of sorts in recent days with the European Central Bank last Wednesday sticking with a 50-basis point rate increase, judging it could firewall its monetary policy actions to fight high inflation from those needed to calm fears about financial stability.

Analysts at Goldman Sachs, however, predict a pause at the meeting this week owing to the current volatility and helped by a sharp drop in near-term inflation expectations. The investment bank then expects three more 25 basis point hikes in May, June, and July, with the policy rate peaking in the 5.25-5.5% range.

"While policymakers have responded aggressively to shore up the financial system, markets appear to be less than fully convinced that efforts to support small and midsize banks will prove sufficient," they wrote. "We think Fed officials will therefore share our view that stress in the banking system remains the most immediate concern for now."

(Reporting by Lindsay Dunsmuir; Editing by Andrea Ricci)