Futures markets bet on an interest rate increase
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Illustration: Brendan Lynch/Axios
For two years now, the Federal Reserve policy discussion has been all about interest rate cuts: when they'll arrive, how big, how many. The Iran war and accompanying energy price shock have flipped the script.
The big picture: Futures markets now price in meaningful odds that the Fed's next move will be an interest rate increase. It's at odds with Fed officials' own stated expectations — and reflects investor fears that in a sixth straight year of too-high inflation, the central bank will find its credibility on the line.
- The rate hike bet essentially projects that the inflationary surge from the war will be powerful enough to overcome its hit to consumers, the Fed's own institutional inertia, and the president's stated desires for the central bank.
- That's not to say it couldn't happen, but it would likely require a more dire progression of price pressures and more minimal damage to the economy than is currently implied by prices of oil and gas futures.
By the numbers: As of Tuesday morning, the CME FedWatch tool put 26% odds on the Fed's policy rate being higher at the end of the year. Those odds were zero a week ago.
- That prospect of higher rates is also evident in two-year Treasury notes, which yield 3.9%, higher than the current Fed target range of 3.5% to 3.75%. That pricing makes sense only if investors believe higher rates are on the way in the next couple of years.
State of play: Fed officials themselves have sounded dismissive of the possibility of higher rates while acknowledging it can't be ruled out.
- Chicago Fed president Austan Goolsbee acknowledged the possibility in an interview Monday, but described it as a kind of symmetry in which significant rate cuts are also plausible.
- "We could be back to the environment with multiple rate cuts for the year if inflation behaves," he said on CNBC. "I could see circumstances where we would need to raise rates if it was going a different way, and inflation was getting out of control."
- Chair Jerome Powell said last week that rate hikes aren't the base case for the "vast majority" of Fed officials.
Zoom out: Central banking doctrine holds that monetary policy should mostly look through energy price shocks, as they dampen growth and cause only a one-time adjustment to the price level rather than ongoing inflationary pressure.
- The exceptions to that rule come when inflation expectations and price-setting behavior are already at risk of coming unmoored, and when the energy price shock flows through to broader price increases.
- That's what puts the Fed of 2026 in a dilemma: Higher prices for gasoline and natural gas may be a one-time adjustment, but they are coming on the heels of five consecutive years of stubborn, above-target inflation.
Between the lines: It doesn't help that it arrives at a moment when the Fed's vaunted independence from politics is under profound question, as the Trump administration cajoles the Fed to deliver lower rates.
Flashback: There are some echoes of the spring and summer of 2008, when the economy was faltering while oil prices were surging.
- At the European Central Bank, president Jean-Claude Trichet raised interest rates twice — an error, with the benefit of hindsight, as it left the European economy worst-positioned to shoulder the financial crisis that intensified that fall.
Yes, but: It's hard to imagine the Fed — under either Powell or Kevin Warsh, Trump's nominee to succeed him — raising rates amid a weak labor market, fuel prices depressing consumer spending, and tightening financial conditions due to geopolitical strife.
- The most plausible rate hike scenario looks more like this: A surge in energy prices doesn't stay contained but rather spreads more broadly to consumer prices; longer-term inflation expectations rise; yet the job market and GDP growth hold up OK.
