Do you see the Fed hiking rates by 75 bps or by 100 bps in the July FOMC meeting?

As of now the market views are divided on whether the Fed will hike rates by 75 bps or by 100 bps when they meet in July. If you go by the CME Fedwatch, it has been assigning a high probability to a 100 bps rate hike in July. That would take the rates to the range of 2.75%-3.00%; very close to its yearend target of 3.41%. It would also effectively revise the interest target for the end of 2022 upwards to 3.60%, nearly 110 above the neutral rate of 2.5%.

Now, going 110 basis points above the neutral rate has its own downside risks, in that it could start impacting the output and growth of US GDP. If you look at the growth in GDP for the first 2 quarters, it is already in the negative and a sharper rate hike would almost make recession in the US inevitable. Such aggressive rate hikes may control inflation but it would come at a big cost in the form of negative GDP. That is hardly a very healthy and conducive scenario at a time when the post-pandemic recovery has still been unstable and varied.

In my view, there could be 3 reasons why the Fed may eventually stick to 75 bps in July, not bothering about what the CME Fedwatch says for now.

1. Firstly, the US government and the Fed would not want to risk a full-fledged recession when the recovery is still so very nascent. If the rate hike is too sharp, the likely impact is that the inflation may be curbed, but it would curbed along with growth too.

2. The second reason is the risk of divergence that the US central bank may end up vis-a-vis the rest of the world. For instance, the US may end up being the sole hawk and may risk monetary divergence which is not a good idea in these interconnected markets.

3. Lastly, there is an issue of credibility and future flexibility on the rates front. Let me explain. If the Fed forces 100 bps rate hike and it kills growth, then the credibility of the Fed as a growth friendly central bank suffers. Also, if 100 bps rate his not enough immediately, then it reduces the leeway for future action. Hence 75 bps looks likely.