Why the Fed Should Raise Rates by Half a Percent

Having oscillated between anticipating another 50-basis-point interest-rate increase by the Federal Reserve next week or a downshift to 25 basis points, traders have settled solidly on the latter, guided both by Fed officials’ comments and by media reports. Some economic and market indicators support such a policy action, but it’s far from uniform. Indeed, my broader analysis of economic and financial conditions would favor the Fed raising rates by 50 points, also on account of risk management, credibility and the persistent misalignment between market pricing and the central bank’s forward policy guidance for 2023.

Through the details of the Fed’s December policy meeting and numerous speeches since, policymakers have guided the markets to expect the central bank to increase rates by 25 basis points, establish a peak rate of just more than 5% for this hiking cycle and keep it there for the rest of 2023. Despite what has been an unusually uniform and consistent message from Fed officials, the markets continue to refuse to fully price in this policy guidance. Instead, traders expect the Fed to cut rates in the second half of the year and are backing that up with their bets.

This leaves the Fed with three policy priorities for next week’s policy meeting: Convince the markets of its policy outlook for the year; implement a policy action consistent with this; and, therefore, partially repair its credibility, which was damaged by its gross mischaracterization of inflation for almost all of 2021 and, after that, too modest an initial policy response.

The Fed seems to believe that a 25-basis-point increase is consistent with this goal, down from 50 points in December and, before that, a record-breaking four consecutive 75-point increases. The case made for such a downshift goes beyond the expectation that an already declining inflation rate will continue to fall in the months ahead. It also appears consistent with the significant level of economic fluidity, domestically and internationally — or, as framed by Fed Chair Jerome Powell, the notion of walking slowly in a dark room to better feel one’s way through it. This consideration takes added importance in the context of forward-looking indicators suggesting a still-high probability of recession, including deeply inverted segments of the US Treasury yield curve.