Fed expected to raise interest rates and signal more hikes are coming

  • The Fed is likely to sound hawkish when it announces an expected rate hike Wednesday and releases its new economic outlook and interest rate forecast.
  • The 2-year Treasury note, which most reflects Fed policy, rose to a new 10-year high Monday, ahead of the meeting.
  • The Fed is expected to sound more confident about the economy, raising its forecast for growth and removing language form its statement that described its policy as easy.

The Fed is expected to raise interest rates by a quarter point Wednesday and indicate it plans to keep hiking them in what many expect to be a hawkish message for markets.

Wall Street economists expect the Fed to make a number of changes that reinforces a hawkish tone, including raising its growth forecasts, sounding more confident about the outlook and dropping language that says its policy is accommodative.

The Fed releases its statement and revised economic and interest rate forecasts at 2 p.m. ET Wednesday, and Fed Chairman Jerome Powell holds a briefing at 2:30 p.m. Ahead of the meeting, major U.S. stock exchanges pointed up in Wednesday's premarket. The 2-year Treasury note yield Tuesday rose to 2.84 percent, its highest level since 2008. The 2-year most reflects Fed policy but the 10-year was also moving higher, touching just below its year high of 3.12 percent Tuesday.

"I think there's one very key thing we have to watch, … which is they increase their long-term growth forecast. Currently it's 1.8 percent," said Jim Caron, portfolio manager at Morgan Stanley Investment Management. "If they take it up to 1.9 percent, that's a pretty important signal."

A higher longer-term growth rate is both hawkish and bullish. It means the Fed is also likely to raise its near-term forecasts, but it also means it sees a sustainable higher pace of growth for the economy, implying higher corporate earnings growth.

Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch, also expects the Fed to boost its growth forecasts, for the near term and the longer term. "I don't think the Fed is going to come out and sound like they're on the warpath to raising rates. I think they're going to sound more measured — 'The data has been strong, and we're more confident in our forecast,'" said Cabana.

Cabana also said he expects the Fed to "sound more confident in the outlook, more confident to keep going the way they have been going, and I think the market will probably not be sorry it's pricing in ongoing rate increases from the Fed." He said the market is now pricing in two hikes for next year, nearly double what it was expecting just several weeks ago. "It's just a fact the data in the U.S. continues to be strong. Some of the worst fears over trade were not realized," he said.

He expects the Fed will keep its forecast of four hikes for this year, three for next, one for 2020, and in a new forecast, add about a half a hike in 2021. That would bring the fed funds rate to 3.50 percent.

Source: Bank of America Merrill Lynch

J.P. Morgan economists expect the Fed to note a change in its policy stance. "We believe the most notable change to the statement will be to drop the reference to policy being 'accommodative,' and to make no further assessment of whether policy is stimulative or restrictive. We expect Powell will continue to play defense at the press conference, and to not push any strong views on the outlook," J.P. Morgan economists said.

The Fed has been expected to move away from describing policy as accommodative. Cabana said he expects the Fed to remove that sentence from its statement altogether.

BofA strategists said the removal of the word could seem dovish since the Fed sees policy getting closer to neutral and will then stop raising rates. But they said they believe it is hawkish since the Fed believes the economy is strong enough that it no longer needs to be accommodative and can transition to the next stage of rate hikes.

Neutral is the level where rates are viewed as neither stimulating or slowing the economy.

Robert Tipp, chief investment strategist at PGIM Fixed Income, said the Fed is at a transition point, and he views the approach of a neutral level differently.

He expects the Fed to raise rates Wednesday and in December, but the Fed may be different next year. "Now we could be getting to another inflection point. This was the year where they could hit every meeting. The economy is doing well, there's a little bit of stress with trade, emerging markets, but not anything enough to give them sufficient pause to take them off course," he said. "The dynamic is likely to change a great deal. They're going to pass from an environment where the policy is pretty accommodative to one where the policy is pretty neutral."

Tipp said sometime next year, "we're going to run into a different motif, where after every meeting you're going to ask yourself are they pausing or skipping a meeting?"

"The debate at the September meeting will be intense (as we will see later in the minutes) on what the neutral rate actually is," said Diane Swonk, chief economist at Grant Thornton. "Governor Lael Brainard, who is a powerful voice on the board, appears to have shifted her view recently, arguing that the stronger economy justifies a higher neutral rate. This suggests a Fed that is chasing rates up instead of down."

Swonk said the Fed risks overshooting with its rate hikes, and that it is reacting now to an economy that is performing better than expected.