Citadel Securities said in its latest report that markets may be underpricing the odds of a Federal Reserve rate hike at this week’s meeting. The firm said recent employment and inflation data have softened somewhat, but geopolitical tensions and swings in energy prices are still adding upward pressure to prices.
A surprise 25 basis-point increase this week, the report said, would help strengthen Federal Reserve Chair Kevin Warsh’s inflation-fighting credibility. It would also send a clearer signal that the era of forward guidance is ending, with policymakers no longer giving markets extensive advance hints about the likely path of monetary policy.
A 40% implied chance of a hike this week
Based on derivatives pricing, the report said interest-rate swap markets currently imply about a 40% chance of a quarter-point rate increase on Wednesday this week. Compared with the high degree of certainty that often surrounded Fed decisions in recent years, that points to an unusual level of uncertainty in the market.
The report also said traders have fully priced in a September rate hike. Citadel Securities argued that moving this week instead of waiting until September would have a more visible economic impact, and that markets may once again be underestimating how far and how firmly the Fed is shifting in a hawkish direction.
Warsh credibility and the end of forward guidance
ABMedia, citing the report, said Kevin Warsh has repeatedly stressed his commitment to restoring price stability. Citadel Securities said a rate increase this week would bolster his anti-inflation credibility and show that the Fed is no longer leaning too heavily on forward guidance to pre-signal future rate decisions.
By cutting back on advance messaging, the report said, the Fed would highlight more independence and flexibility in its decision-making. Acting earlier could also influence company pricing and wage demands before inflation becomes more deeply rooted, which may reduce the amount of policy tightening needed later.
Oil prices and geopolitics remain in focus
The report said weaker employment and inflation readings recently had lowered expectations for a July hike for a time, but the overall structure of the labor market remains stable and inflation risks are still elevated.
It also pointed to continued uncertainty tied to the Middle East. Although the United States paused its routine military operations against Iran, briefly easing tensions, the report said the Iran-backed Houthi armed group continues to threaten Saudi Arabian export routes in the Red Sea region. Crude oil prices have risen about 20% this month, according to the report. That sharp increase in energy prices may become a key factor in any Fed decision to raise rates this week.