The Fed will raise rates again. But it’s playing with fire

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The Federal Reserve is all but guaranteed to announce Wednesday that it will once again raise interest rates. But investors are hopeful it will be a smaller increase than the last four hikes.

Traders are betting on just a half-point increase. Federal funds futures on the Chicago Mercantile Exchange show an 80% probability of a half-point hike.

The Fed bumped up rates by three-quarters of a percentage point in the past four meetings (June, July, September and November). That followed two smaller rate hikes earlier this year. The central bank’s key short-term interest rate, which sat at zero at the beginning of the year, is now at a range of 3.75% to 4%.

The hope is that inflation pressures are finally starting to abate enough that the Fed can pivot — Fed-speak for a series of smaller rate hikes -— to avoid crashing the economy into a recession.

But it may not be that simple. The government reported Friday that a key measure of wholesale prices, the Producer Price Index, rose 7.4% over the past 12 months through November. That was a bit higher than the expected rate of 7.2% but a marked slowdown from the 8% increase through October.

The more widely watched Consumer Price Index data for November comes out Tuesday, just a day before the Fed announcement. CPI rose 7.7% year-over-year through October.

As long as inflation remains a problem, the Fed is going to have to tread cautiously.

“Inflation has probably peaked but it may not come down as quickly as people want it to,” said Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research.

Jones still thinks the Fed will raise rates by only half a point this week and may look to hike them just a quarter point in early 2023. But she conceded that the Fed is now sort of “making it up as they go along.”

The other problem: The Fed’s rate hikes this year have had limited impact on the economy so far. Yes, mortgage rates have spiked and that has severely hurt demand for housing, but the job market remains strong. Wages are growing, and consumers are still spending. That can’t last indefinitely.

“The cumulative impact of higher rates are just beginning. Hence, the Fed has to step down its pace a bit,” Jones said.

So investors are going to need to pay attention not to just what the Fed says in its policy statement about rates and what Powell talks about in his press conference. The Fed also will release its latest projections for gross domestic product growth, the job market and consumer prices Wednesday.

In September, the Fed’s consensus forecasts called for GDP growth of 1.2% in 2023, an unemployment rate of 4.4% and an increase in personal consumption expenditures, the Fed’s preferred measure or inflation, of 2.8%. It seems likely that the Fed will cut its GDP target and raise its expectations for the jobless rate and consumer prices.

The likelihood of an economic downturn is increasing, and the Fed’s projections may reflect that. But the Fed is not expected to start cutting interest rates until 2024 at the earliest, so it may be too late for the central bank to prevent a recession.

“A pivot or pause is not a cure-all for this market,” said Keith Lerner, co-chief investment officer at Truist Advisory Services. “Rate cuts may be too late. Recession risks are still relatively high.”

The US economy isn’t in a recession yet. But are American shoppers tapped out? We’ll get a better sense of that Thursday after the government reports retail sales figures for November.

Economists are actually forecasting a small dip of 0.1% in retail sales from October. But it’s important to put that number in context. Retail sales surged 1.3% from September and 8.3% over the past 12 months.

So it’s possible consumers were simply getting a head start on holiday shopping. Inflation has an effect on the numbers too, since retail sales have been impacted (positively) by the fact that people have to spend more money for stuff.

One market strategist also pointed out that as long as price increases continue to slow, consumers will feel more confident as well.

“Everybody has been talking about inflation this year. Going forward, it will be more about disinflation in 2023 or 2024,” said Arnaud Cosserat, CEO of Comgest Global Investors.

What does that mean for investors? Cosserat said people should be looking for quality consumer companies that still have pricing power and can maintain their profit margins. Two stocks that his firm owns that he said fit that bill: Luxury goods maker Hermes

(HESAF) and cosmetics giant L’Oreal

(LRLCF).

Monday: UK monthly GDP; earnings from Oracle

(ORCL)

Tuesday: US Consumer Price Index; Germany economic sentiment

Wednesday: Fed meeting; EU industrial production; UK inflation; earnings from Lennar

(LEN) and Trip.com

(TCOM)

Thursday: US retail sales; US weekly jobless claims; ECB and Bank of England rate decisions; earnings from Jabil

(JBL)

Friday: Eurozone PMI; UK retail sales; earnings from Accenture

(ACN), Darden Restaurants

(DRI) and Winnebago

(WGO)