Investors are on edge as the Federal Reserve gears up for its policy decision next week. Some are even starting to brace for a big surprise.
What's happening: New inflation data on Tuesday showed that prices aren't easing as quickly as Wall Street had hoped. Markets plummeted as the report stoked fears that the central bank and Chair Jerome Powell would decide to hike rates more aggressively, inflicting serious economic pain.
Tuesday's alarming inflation report was the last before Federal Reserve officials convene for their next decision on interest rates, and it signaled to markets that the Fed won't pull its feet off the accelerator in its fight to moderate price increases anytime soon.
Investors are putting the odds of a three-quarter percentage point hike next week at 75%, according to CME FedWatch data. But some finance bigwigs have started discussing a scenario in which the Fed raises rates by a full percentage point for the first time in its modern history.
The odds for a full point hike are hovering around 25% in the wake of the inflation report, up from 0% one week ago. Economists at the brokerage Nomura Securities changed their forecast from 75 basis points to 100 basis points.
Larry Summers, the former Treasury Secretary and President Emeritus at Harvard, wrote on Twitter that he doesn't think gradual increases in interest rates have been working to tamp down high prices. The Fed has hiked rates four times already this year, and inflation remains near 40-year highs.
Markets might even surprise to the upside if they are reassured that the Fed is taking inflation seriously, said Summers. It's better to take a "rip off the bandaid" approach. He added, "I would choose a 100 basis points move to reinforce credibility."
But markets don't often take kindly to interest rate hikes, which can negatively impact earnings and stock prices.
A percentage point hike would also push the federal funds rate into what the Fed considers a restrictive range — where it says economic growth tends to slow and unemployment rates tend to rise. That limits the Fed's chances of executing a soft landing, the Goldilocks situation where the Fed cools the economy enough to lower inflation but not enough to cause a recession.
Still, some economists think shocking markets is a good thing, and at least one Fed official agrees.
Minneapolis Fed president Neel Kashari said last month that he was happy markets tanked after Powell warned of pain ahead. It meant that people understood the seriousness of the Fed's commitment to getting inflation rates back down to 2%, he said.
The Fed wants "a weaker stock market. They want higher bond yields," former New York Federal Reserve President Bill Dudley told my colleague Matt Egan last month. "The stock market I think is finally catching onto that."
Higher bond yields, lower stock prices and widening credit spreads that make it more expensive for companies with weaker balance sheets to borrow are necessary to tighten financial conditions.
The bottom line: It's unlikely that the Federal Reserve will raise rates by a full percentage point next week. The consensus amongst economists and Wall Street analysts is still for a 75 basis point hike, and Powell likes to communicate and prepare markets for any changes.
But that doesn't mean a larger hike isn't coming at the November meeting.
"I wouldn't discount a 100 basis point rate hike," Marvin Loh, senior strategist at State Street, told me. "It was only a few months ago when a 50 basis point hike seemed unthinkable."
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