The "most uncertain" one in years! Will tonight's Federal Reserve give a "shock"?

Author: Wall Street Journal

Tonight's Federal Reserve decision is likely to remain "on hold," but what the market is truly worried about is not the baseline scenario, but rather a rare unexpected rate hike or a pause with sufficiently hawkish wording.

At 2:00 AM Beijing time on July 30, the Federal Reserve will announce its latest interest rate decision. This meeting will not include a dot plot or economic forecast updates, and the target range for the federal funds rate is expected to remain at 3.50%-3.75%. According to a Reuters survey, all 104 respondents predict that rates will remain unchanged. However, the money market still assigns about a 32% probability of a rate hike this week and factors in a tightening of about 42 basis points for the year, making tonight one of the most uncertain meetings in recent years.

The uncertainty comes from the tug-of-war between two forces. The June CPI was significantly below expectations, non-farm employment was weaker than expected, and oil prices fell before the meeting, all providing the Federal Reserve with space to continue waiting. However, inflation remains above target, the situation in the Middle East and oil prices are volatile, some Federal Reserve officials have recently expressed hawkish views, and Chairman Waller has yet to establish a clear policy record, making it difficult for the market to completely rule out the risk of a rate hike.

UBS Chief U.S. Economist Jonathan Pingle stated, the level of uncertainty he feels about the upcoming Federal Reserve decision is the highest in 20 years— the last time he felt similarly was when Bernanke had just taken over as Fed Chair. "Waller will lead the policy direction in the upcoming meetings, and we know almost nothing about how he views monetary policy."

For investors, the risks are concentrated on short-term rates, the immediate reactions of the dollar and U.S. stocks. According to JPMorgan Market Intel, if the Federal Reserve unexpectedly raises rates by 25 basis points, the S&P 500 index could drop by 1.5%-2%; if rates are raised by 50 basis points, the decline could expand to 2%-4%. Even if rates remain unchanged, as long as the statement and press conference lean hawkish, it could limit the rebound of risk assets.

Market consensus is to pause, but pricing is not calm

From a traditional forecasting perspective, this decision seems to have no suspense. According to a Reuters survey, all 104 economists expect the Federal Reserve to keep rates unchanged. Among them, 78 expect no rate adjustments for the remainder of the year, while only 6 expect a rate cut.

However, the same survey shows that 66% of respondents believe the likelihood of a rate hike this year is "high," which is significantly different from the "low" mainstream judgment in June. Market pricing also indicates that investors are paying for the tail risk of a rate hike. Traders are currently not only assigning about a 30% probability of a rate hike this week but also fully factoring in a 25 basis point hike before September and nearly 50 basis points of tightening before March next year.

Goldman Sachs believes this pricing indicates that the outcome of this meeting is "exceptionally uncertain." If the Federal Reserve raises rates, it would be considered a rare unexpected action; if it does not raise rates, the market will quickly reassess the previously factored-in rate hike risks. Ian Lyngen of BMO Capital Markets noted that since 2015, the average error in traders' predictions of the final rate decision the day before a Federal Reserve meeting has been only 2.4 basis points, but this time the market is more likely to experience a more severe immediate reaction than usual.

Data supports waiting, but inflation risks remain

The reasons supporting the Federal Reserve's pause mainly come from the latest data. The June CPI was below expectations, weakening the rate hike bets that had arisen from Waller's hawkish statements. Waller had stated that if the June core CPI was hot, a rate hike should be considered; if the data was cold, he would need to see more similar readings before considering it a clear signal.

The labor market has also given the Federal Reserve more time to observe. June non-farm employment was weaker than expected, with the previous values revised down, resulting in a net revision of a decrease of 74,000 jobs over two months, compared to an increase of 93,000 jobs previously. Although the unemployment rate slightly decreased, the data suggests that this may primarily stem from a decline in the overall labor participation rate.

Oil prices are also a key variable. The conflict between the U.S. and Iran escalated after the last meeting, with relevant memorandums of understanding being violated and both sides resuming strikes. However, during the weekend before the meeting, strikes paused, geopolitical risk premiums decreased, and oil prices fell, which helps ease inflation expectations. Federal Reserve officials have also previously warned against responding too quickly to what may only be temporary supply shocks.

The problem is that underlying inflation remains significantly above target. Morgan Stanley pointed out that upside risks include persistently high oil prices, a more hawkish Federal Reserve reaction function, and AI-driven investment pushing neutral rates higher. Goldman Sachs also believes that the combined impact of tariffs, war, and AI statistical errors on monthly inflation may weaken in the future, but uncertainty remains high; if inflation improvement stalls, discussions about rate hikes within the Federal Reserve will heat up again.

Communication in the Waller era itself is a risk

The last FOMC meeting chaired by Waller was also his first meeting. At that time, the statement was significantly shortened, forward guidance language was removed, and the committee's commitment to bringing inflation back to the 2% target was strengthened. This means that even minor wording changes in this meeting could be amplified in the market's interpretation.

Morgan Stanley expects that this statement will likely remain unchanged, including reiterating the "ample reserves" policy, describing economic activity as still "expanding at a robust pace" under high uncertainty, the unemployment rate as "little changed," and inflation as still "high." Since there are no economic forecast summaries this month, decision-makers do not need to reset market expectations through the dot plot.

The press conference may be more important. Waller is expected to be asked about the impact of the Middle East conflict on inflation, the newly announced chair working group, and whether the latest data will advance the policy action timeline. Goldman Sachs expects that Waller will not provide clear policy signals and may emphasize that all options remain open, with future decisions depending on data.

Credit Agricole believes that the Federal Reserve is entering a new phase with more limited forward guidance, which will make more meetings truly "live meetings." The bank expects the Federal Reserve to remain on hold this time and believes that the data since the last meeting has at least bought time for a continued pause. Regarding the five working groups newly established by Waller, Credit Agricole does not expect significant updates in the near term, and relevant recommendations may not be completed until close to the end of the year, which also means that changes to balance sheet policy are unlikely in the short term.

Divergence widens, and a pause may also accompany dissent, focus on opposing votes

The divergence within the Federal Reserve is the core of the uncertainty for this meeting. In the June forecast, among the 18 participants who submitted predictions, 9 expected at least one rate hike this year. Subsequently, several officials' statements indicated that they would be willing to consider further tightening if inflation stagnates.

Both Waller and Cook stated that they might consider tightening policy if the anti-inflation process stalls. 2026 voter Logan and Hammack's speeches were more hawkish. Logan argued that the policy rate should be moderately higher to better balance prospects and risks, and believed that some restrictive policies are still needed to help bring inflation back to target. Hammack directly stated that the Federal Reserve may need to consider raising rates.

Therefore, even if rates remain unchanged, there may still be opposing votes. From recent comments alone, if the Federal Reserve chooses to pause, there could be 2 to 4 dissenting votes in favor of a rate hike. Goldman Sachs expects that this statement may acknowledge the inflationary upside risks brought about by geopolitical conflicts and that at least one committee member may vote in favor of a rate hike.

Bank of America analyst Mark Cabana expects the Federal Reserve to keep rates unchanged on Wednesday, but this may attract opposition from regional Fed presidents like Lorie Logan and Beth Hammack. He also stated that if the market does not rule out the risk of a rate hike, strategists will not rule it out either.

A few institutions bet on a "shock" rate hike

Although the mainstream view remains to pause, some institutions are explicitly betting on an unexpected rate hike. Citadel Securities has become a notable outlier, with its macro strategy chief Frank Flight changing the baseline scenario to a 25 basis point rate hike this week. He believes this will strengthen Waller's credibility in fighting inflation and "clearly end the era of forward guidance."

PGIM Global Bond Chief and Chief Investment Strategist Robert Tipp also stated that the market may be underestimating the probability of action on Wednesday. He believes that Waller has actually set the stage for a rate hike, and if the decision is delayed now, it may increase the probability of a 50 basis point hike in September.

Wrightson ICAP Chief Economist Lou Crandall stated that the Federal Reserve has no sufficient reason not to raise rates. Bond market veteran Harley Bassman even argued that the Federal Reserve should raise rates by 50 basis points at once to strengthen its anti-inflation credibility.

However, Goldman Sachs still believes that most voters are unlikely to push for a rate hike this week after the soft June inflation data. The bank also pointed out that historically, the Federal Reserve avoids making unexpected rate hikes during meetings, especially in meetings without economic forecast summaries, as officials may be more concerned about the market overinterpreting their intentions.

Asset reactions: rate hikes are the biggest shock, hawkish pauses are also not easy

JPMorgan Market Intel lists "hawkish pause" as the baseline scenario, with a probability of 50%. In this scenario, the S&P 500 index may rise by 0.25% to fall by 0.50%. The logic is that the Federal Reserve will pause due to the resilience of the labor market and growth, but will continue to emphasize vigilance against inflation.

If there is an unexpected rate hike of 25 basis points, JPMorgan expects the S&P 500 index to drop by 1.5%-2%, with the Nasdaq 100 index potentially experiencing a larger decline. If rates are raised by 50 basis points, the S&P 500 index could drop by 2%-4%. If it is a "dovish pause," meaning rates remain unchanged and communication is softened, the S&P 500 index may rise by 0.50%-1%. In the options market, options expiring on July 29 are factoring in about 0.8% volatility for the S&P 500, lower than the recent CPI event's pricing of about 1.1%.

In terms of foreign exchange, Goldman Sachs' forex team believes that if the Federal Reserve pauses, the dollar may experience tactical weakness, but as long as energy prices remain high, this weakness may be short-lived. In the medium term, if the Federal Reserve maintains rates unchanged as expected by the bank's economists, it will exert moderate but controllable pressure on the dollar against G10 currencies.

The focus of the interest rate market is on the front end. Goldman Sachs' interest rate trading desk believes that the market may misinterpret the "lack of forward guidance" as intentional ambiguity. This trading desk tends to believe that if the Federal Reserve Board does not support a rate hike, the hawkish voters do not have enough votes to push for action this week. However, if there is a pause in July, Waller may still provide a hawkish pause and lay the groundwork for a rate hike in September.

In terms of commodities, Goldman Sachs' oil trading desk stated that the oil risk premium is rapidly dissipating due to the U.S. and Iran forming a de facto ceasefire over the weekend and negotiations to reopen the Strait of Hormuz progressing. However, upside risks have not disappeared; if attacks on Saudi oil facilities or production continue, oil prices may rise again. Gold has fluctuated within a range of about $250 over the past two months, and the trading desk maintains a long-term bullish outlook but tends to engage in tactical trading around news events.

This means that tonight's key issue is not just whether rates change, but how Waller explains "no change" or "change." In a context where the market has already paid for the risk of a rate hike and economists almost unanimously expect a pause, whichever side the Federal Reserve chooses could bring a significant shock to the market.