The Fed's flight of the doves
Investors are pricing in a strong chance of a rate hike before November. But it's growing less likely that the Fed's inflation hawks will get their way.
NEW YORK (CNNMoney.com) -- Unless the Federal Reserve wants to completely freak out Wall Street, the central bank is not going to raise or cut interest rates Tuesday. The market is prepared for no change.
But how long will the Fed keep its key overnight bank lending rate at 2%? That's another question entirely.
Before the crisis of confidence that shook mortgage giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) last month, there had been a growing sense that the Fed could focus on fighting inflation and that rate hikes would lead to a stronger dollar and further pullback in oil prices.
But calls for higher rates have died down a bit, the thinking being that an increase could block the road to economic recovery.
Still, you wouldn't know this by looking at the closely-watched federal funds futures contracts on the Chicago Board of Trade, which track the probability of future rate movements for several months out.
According to these contracts, traders are pricing in a 64% chance of a rate hike by the Fed's late-October meeting. After tomorrow's meeting, the central bank's Federal Open Market Committee (FOMC) meets again on Sept. 16 and then has a two-day session that wraps up on Oct. 29.
So why are some investors still betting on a rate hike in the next few months? And are they foolish to be doing so?
On the one hand, it seems highly unlikely that the Fed would want to make waves less than a week before Election Day.
But as I maintained in a column back in May, I think the Fed has to try and focus more on data and not worry about how its decision will be spun by political wonks.
In fact, the usual knee-jerk reaction to a rate hike - that they're bad - may not hold water this time. After all, low interest rates are part of the reason behind soaring gas and food prices, and partially behind the anemic returns people are getting on their savings accounts.
So how will we know what the Fed intends to do? As is usually the case when the Fed doesn't actually change interest rates, the Fed's language in its statement on Tuesday will be key.
While the Fed was cutting rates last fall and earlier this year, its statements were what Fed watchers would call very "dovish," indicating more concern about downside economic risks than inflation. That suggested the Fed would keep cutting rates.
But the Fed signaled when it cut rates in April that it was getting ready to pause. The Fed said in that statement that "the substantial easing of monetary policy to date...should help to promote moderate growth over time and to mitigate risks to economic activity."
And lo and behold, the Fed kept rates steady in June. And in that statement, the central bank started to sound more "hawkish," ringing the inflation alarm and hinting that rate hikes might be in the cards.
"Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased," the Fed said.
If the Fed keeps that language intact in Tuesday's statement, that would probably be interpreted as a sign that it intends to raise rates soon.
In addition, the market will be keeping an eye on possible dissension at the Fed. In June, Dallas Fed president Richard Fisher voted for a rate hike. He was the only member to do so and most Fed watchers expect him to vote for a rate hike tomorrow.
But there is speculation that Philadelphia Fed president Charles Plosser, who voted against the rate cut in April and is also known as an inflation hawk, may join Fisher in calling for a rate hike.
And there is a case to be made that the Fed will and should remain more worried about inflation. The personal income and spending figures for June released Monday morning showed that one of the Fed's key inflation gauges was a bit higher than where the Fed usually likes it to be.
Still, it's difficult to imagine the Fed being that hawkish in the wake of what happened to financial stocks last month as well as continued woes in the job market. At the same time, oil prices have finally begun retreating.
"The 19% oil price decline coupled with the steady deterioration in employment and housing figures is an undisputable combination for the FOMC to issue a more dovish (or less hawkish) statement," wrote Ashraf Laidi, chief currency strategist with brokerage firm CMC Markets US in a note to clients Monday morning.
Fed chairman Ben Bernanke essentially contradicted the language in the June statement about downside economic risks diminishing when he told Congress that "the possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth."
Bernanke added that "monetary policy makers will need to carefully assess incoming information bearing on the outlook for both inflation and growth."
So if the Fed includes language in tomorrow's statement that sounds more like Bernanke's congressional testimony than what it said in late June, then that might finally put the kibosh on the notion that there will be a rate hike between now and November.
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