The big risk in Wall Street’s bet on interest rates

In the immediate future, if the markets’ expectations of another material fall in the rate are borne out, it is probably that the Fed would choose to lift the upper end of its targeted range by only 25 basis points when it next meets at the end of this month. That would keep the markets’ thesis that US rates will be falling in the second half of the year alive.

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If the data disappoints and shows higher-than-anticipated inflation, it is probable that meeting will raise the federal funds rate by 50 basis points. The Fed’s view that the federal funds rate will shift above five per cent and still be there at the end of the year will be buttressed.

That wouldn’t be good news for investors, given that the countervailing view is already priced into shares, bonds and other risk assets.

The outcomes aren’t, of course, just about the financial markets. The Fed seems to be convinced that it will take a material rise in unemployment and, inevitably, a recession to drive inflation out of the economy. The markets are convinced a recession is predestined.

The risk is one of over-kill. The Fed was wrong about the trajectory of inflation when it was on the way up, erroneously believing it would be “transitory.”

It could, given the lag between monetary policy decisions and their real-world effects, as easily be as wrong about the pace at which inflation falls, tipping the US into an unnecessarily severe recession rather than the “softish landing” that financial markets still think is possible.

There are Fed officials who believe that, while not necessarily altering its expectation of the “terminal” rate – the peak rate in this cycle – the Fed could use smaller increments (25 basis points or less rather than 50 basis points, for instance) to buy more time to gauge the impact of its decisions.

An outcome on Thursday evening which conformed to the markets’ expectations would make it more likely that the Fed adopted that strategy and would reduce the risk of over-kill.

The more pessimistic would argue that if the Fed isn’t forceful enough in the early part of this year it could lay the foundations for another surge in inflation that would undo much of the heavy lifting it has already undertaken and inflict even more pain on US households and businesses.

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The dominance of the US markets within global markets, the significance of the US economy and the US dollar within the global economy and the influence the Fed’s rate-setting has over other central banks and their policies mean its decisions and their outcomes have implications for economies, individuals and businesses well beyond the US borders.

Last year the Fed faced the relatively straightforward task of raising US rates until inflation stopped increasing and the inflation rate started falling back, which it did.

This year the task is far more complicated because the Fed will have to make the trickier judgement of how much of an increase is enough, and when that moment should occur, to ensure the inflation rate will fall into its targeted range over time. The consequences of a misjudgement in either direction would be severe.