With nearly all the significant data points in the books, the Federal Reserve is barreling toward a decision next week that increasingly looks like a lose-lose proposition. Raise rates too little and the Fed could lose control of inflation. Hike too much and it elevates 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 is facing a high level of second-guessing regardless of which way it turns. “The Fed will overdo it. They’re already overdoing it in my opinion,” said Joseph LaVorgna, chief economist at the SMBC Group and a former high-ranking economic advisor in the Trump administration. “There’s no question we’re going to have a hard landing.” That’s one side of the argument: That the Federal Reserve, in its quest to defeat runaway inflation, already has moved too far too fast to battle a specter that’s slowly fading into the background. More interest 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 rates in 1994 and early 1995. Among those also in that camp is Starwood Capital Group CEO Barry Sternlicht, who called for the central bank to ease its foot off the policy brake. “If the Fed keeps this up they are going to have a serious recession and people will 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 timidly to defeat inflation which is showing signs of slowing only because of an unsustainable drop in gas prices and is instead broadening out and could rage out of control without tougher monetary policy. “We believe it is increasingly clear that a more aggressive path of interest rate hikes will be needed to combat increasingly entrenched inflation stemming from an overheating labor market, unsustainably strong wage growth and higher inflation expectations,” Nomura economist Rob Dent and others said in a client note. Full-point hike on the table Earlier this week, Nomura upped its expectations for next week’s rate decision to an increase of a full percentage point, which would mark the most aggressive increase in Fed history dating back to 1990 when it first started using the fed funds rate as its principal tool for monetary policy. While the move would seem extreme, Dent wrote that it is necessary in the current climate. “We continue to believe markets underappreciate just how entrenched U.S. inflation has become and the magnitude of response that will likely be required from the Fed to dislodge 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 was assigning a 20% probability to a full-point move — down from as high as a 34% chance on Wednesday but still significant, according to the CME Group’s FedWatch Tool that tracks futures contracts. Even considering the idea of a 100 basis point hike is remarkable, considering that up to this week’s inflation data, the market was deliberating between 50 point and and 75 point moves, with 100 nowhere in sight. (A basis point equals 0.01 percentage point.) For their part, policymakers have done nothing to dispel the specter of a third consecutive 0.75 percentage point hike. They are in the quiet period now before the two-day meeting starts on Tuesday, but no doubt are still watching data closely. Thursday saw another round of economic releases that painted a familiar picture: A resilient labor market, as evidenced by relatively low weekly jobless claims, against a tough backdrop for consumers who are barely keeping up with inflation in their retail sales spending. Manufacturing looks to be in contraction, according to readings from the New York and Philadelphia regions, while there was some inflation relief in the form of a 1% decline in import prices. Those 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 into a tailspin on Tuesday. On Wednesday, though, producer prices , which feed into consumer prices through a lagged effect and thus paint a better forward-looking picture, rose less than expected. The only significant releases before next week’s meeting are the University of Michigan consumer sentiment report for September 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 their blinders on’ That leaves the Fed walking the economy on a tightrope and market skeptics saying it will cause a serious problem. Tom Porcelli, chief U.S. economist at RBC Capital Markets, thinks the Fed inflation focus is overdone, and he encouraged policymakers to chart a more cautious path. “They had their blinders on last year, focused only on trying to get the unemployment rate down (yet another lagging indicator) and that turned out to be a dreadful mistake,” Porcelli wrote. “Well here we are again with Powell focused on yet another lagging indicator (inflation) and poised to make yet another mistake, this time by overtightening and ushering in a more meaningful slowing in growth than we need.” Porcelli said he hopes Fed Chair Jerome Powell can see his way past short-term thinking and not “make the mistake of meaningfully overtightening.” “We’d like to think that,” he added. “We’re just not sure we have that much confidence in him.” Next week’s meeting will have several bits 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. That will tell the market not only what policymakers want to do now, but also where they think things are heading 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 central bank’s vice chair of banking supervision. As a group, the Fed for much of 2021 stuck to the idea that inflation was “transitory” and now it’s left to deal with a situation that has caused substantial unrest among investors who will be watching the decision closely. The best approach for now is probably to approve the 0.75 point hike but to reiterate dependency on data for future decisions and to keep options open, said LaVorgna, the SMBC Group economist. “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’ll do that, but that’s how I would do it.”
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