Why the Fed could stun the world on Wednesday

It’s the billion dollar question: Will Federal Reserve officials raise rates or won’t they?

While expectations are very low that the Fed will announce an interest rate hike after its policy meeting on Wednesday, there are some contrarians who believe the Fed could still surprise the markets.

“[C]ommunications from many FOMC members indicate a willingness to prepare markets for the next rate increase, if not move to that rate increase directly,” write Michael Gapen, Rob Martin, and Blerina Uruçi of Barclays Research. “Against this backdrop, we retain our outlook for a rate hike in September. We believe the data have met the Fed’s threshold.”

However, Gapen, Martin, and Uruçi do hedge their bets, noting that the decision is a close call given lackluster inflation data and Fed officials’ potential “unwillingness to buck market pricing,” which could mean foregoing action at the September meeting in favor of sending a strong signal for a hike before year-end.

A slew of mixed data in August, including weak retail sales, soft ISM manufacturing and services readings, and slower-than-expected hiring, lowered market expectations for a September rate hike to 15%, after spiking as high as 42% following Fed chair Janet Yellen’s Jackson Hole speech last month.

The unemployment rate has hovered around 5% for the past year– a level many economists consider to be near full employment. However, the Fed’s preferred measure of inflation, core PCE, remains at 1.6%, below the Fed’s target of 2%.

“In our view, the inflation data have evolved generally in line with the Fed’s forecasts, pass-through effects are clearly fading, most committee members retain a ‘reasonable confidence’ standard for inflation returning to the 2% target, and members are increasingly worried about financial instability,” explain Gapen, Martin, and Uruçi. “Persistent credibility issues, in our view, mean the committee will likely have to ignore market pricing no matter when it moves. Hence, we doubt the situation will become much clearer in December.”

Another measure of inflation, core CPI, rose 2.3% year-over-year in August. This is evidence that the Fed is making progress with its inflation mandate, notes Chris Rupkey, chief financial economist at MUFJ.

“The Fed’s got the wrong darn inflation indicator on their dashboard. No wonder they can’t drive interest rates higher,” said Rupkey. “Let’s see what Yellen does now– whether she confounds market expectations and takes the advice of 8 out of 12 reserve bank presidents and moves rates up ‘cautiously and gradually’ by 25 bps at the September meeting… Stay tuned. The Fed decision is going down to the wire.”

With the economy near full employment and signs of increasing wages, inflation risks are rising, notes Torsten Slok, chief international economist at Deutsche Bank. “In that case, the Fed will no longer have the luxury of being slow, gradual, and cautious, and this continues to be a significant risk to the ongoing hunt for yield in the markets,” he says.