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With nearly all the significant data points in the books, the Federal Reserve is heading for a decision next week that looks increasingly like a lose-lose proposition. Raise interest rates too little and the Fed could lose control of inflation. Hike too much and it increases the risk of torpedoing the economy into a prolonged recession. With a Goldilocks scenario looking more elusive and a hard landing more likely, the central bank faces a high level of second-guessing whichever way it turns. “The Fed will overdo it. They’re already overdoing it in my opinion,” said Joseph LaVorgna, chief economist at SMBC Group and a former senior economic adviser in the Trump administration. “There is no doubt that we will have a hard landing.” That’s one side of the argument: That the Federal Reserve, in its quest to defeat runaway inflation, has already moved far too quickly to combat a specter that is slowly receding into the background. More rate hikes will simply kill an economy that LaVorgna says is “structurally and cyclically nowhere near as strong” as the last time the Fed moved this quickly with interest rates in 1994 and early 1995. Among those also in that camp is Starwood Capital Group CEO Barry Sternlicht, who urged the central bank to ease its foot off the policy brake. “If the Fed goes ahead with this, they’re going to have a severe recession and people are going to lose their jobs,” Sternlicht said on CNBC’s “Squawk Box” in a Thursday interview. The other side of the argument? That the Fed is still acting too restrained to defeat inflation, which is only showing signs of abating due to an unsustainable drop in gas prices and is instead expanding and may spiral out of control without tighter monetary policy. “We believe it is increasingly clear that a more aggressive rate hike path will be needed to combat increasingly entrenched inflation stemming from an overheated labor market, unsustainably strong wage growth and higher inflation expectations,” Nomura said -economist Rob Dent and others in a client note. Full point hike on the table Earlier this week, Nomura upgraded its expectations for next week’s interest rate decision to a full percentage point hike, which would mark the most aggressive hike in the Fed’s history, dating back to 1990, when it first started using the Fed. the fund rate as its main tool for monetary policy. While the move would seem extreme, Dent wrote that it is necessary in the current climate. “We continue to believe that markets are underestimating how entrenched US inflation has become and the scale of the response likely to be required from the Fed to remove it,” he wrote. Traders in the Fed Funds futures market are at least entertaining the idea of a percentage point increase. As of Thursday morning, the market assigned a 20% probability to a full-point move — down from as high as a 34% chance Wednesday, but still significant, according to CME Group’s FedWatch Tool, which tracks futures contracts. Even considering the idea of a 100 basis point increase is remarkable, given that up until this week’s inflation data, the market was considering between 50 point and and 75 point moves, with 100 nowhere in sight. (One basis point equals 0.01 percentage point.) For their part, policymakers have done nothing to dispel the specter of a third straight 0.75 percentage point increase. They are in the quiet period now before the two-day meeting starts on Tuesday, but are no doubt still watching the data closely. Thursday saw another round of economic releases that painted a familiar picture: A robust labor market, as evidenced by relatively low weekly jobless claims, against a tough backdrop for consumers barely keeping up with inflation in their retail spending. Manufacturing appears to be in decline according to readings from the New York and Philadelphia regions, while there was some easing of inflation in the form of a 1% drop in import prices. These data points followed inflation readings earlier in the week that painted a mixed picture. Consumer prices rose more than expected in August, sending the stock market to a standstill on Tuesday. On Wednesday, producer prices rose, which feed into consumer prices through a delayed effect and thus paint a better future picture, although less than expected. The only significant releases before next week’s meeting are the University of Michigan’s September consumer sentiment report on Friday, and August housing starts and building permits on Tuesday, which come just as the real estate market appears to be in its own recession. ‘They had blinders on’ That leaves the Fed walking the economy on a tightrope, and market skeptics say it will cause a serious problem. Tom Porcelli, chief U.S. economist at RBC Capital Markets, believes the Fed’s inflation focus is overblown and urged policymakers to chart a more cautious path. “They had their blinders on last year, focused only on trying to get the unemployment rate down (another lagging indicator) and it turned out to be a terrible mistake,” Porcelli wrote. “Well, here we are again with Powell focused on another lagging indicator (inflation) and poised to make another mistake, this time by over-tightening and initiating a more meaningful slowdown in growth than we need.” Porcelli said he hopes Fed Chairman Jerome Powell can see his way past short-term thinking and not “make the mistake of overtightening meaningfully.” “We’d like to think so,” he added. “We’re just not sure we have that much confidence in him.” Next week’s meeting will have several pieces of intrigue on top of the rate decision. Officials will update their “dot plot” of forecasts on rates as well as those for gross domestic product, unemployment and inflation. It will tell the market not only what politicians want to do now, but where they think things are headed in the future. On top of that, there will be several officials plotting their dots for the first time: Dallas Fed President Lorie Logan, Boston Fed President Susan Collins and Governor Michael Barr, the Fed’s vice chairman for banking supervision. As a group, the Fed for most of 2021 stuck to the idea that inflation was “transient,” and now it is left to deal with a situation that has caused significant unease among investors, who will be watching the decision closely. The best approach for now is likely to approve the 0.75 point increase, but to reiterate the reliance on data for future decisions and to keep options open, said LaVorgna, the economist at SMBC Group. “It’s a very difficult environment and I think they need to send the message of maximum flexibility,” he said. “I don’t know if they want to do it, but that’s how I would do it.”
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