Financial markets have wrung out the last hope of a Federal Reserve interest rate cut in the first quarter of 2007 and are fearful that the central bank will end its policy impasse with a rate increase instead.
Propelling the shift are assessments that US economic growth will not stay low enough for long enough to take a bite out of core inflation, as some Fed officials have forecast.
The squeeze is coming from two directions: trend growth may be lower than the market and the Fed had assumed, while the economy could rebound as soon as the fourth quarter. "We have a rate hike pencilled in for the first quarter, which is conditioned on real GDP (growth) picking up to 3.5 percent, above its potential in the low 3 percent range, and further declines in the unemployment rate," said Christopher Rupkey, senior financial markets economist at Bank of Tokyo-Mitsubishi UFJ in New York.
Fed staff revised down their estimate of the economy's non-inflationary potential at both the August and September Federal Open Market Committee meetings, suggesting more of a slowdown is needed than previously thought to ease pressure on economic resources and bring inflation to heel. "This is one reason for the Fed to hesitate before cutting rates, and perhaps to be more willing to raise rates," analysts at FTN Financial said in a research note.
"As long as the (output) gap is positive, and GDP is below potential, inflation should be under downward pressure. But if the gap is negative, inflation will rise," they said. After a string of 17 straight rate hikes dating over more than two years, the Fed stepped to the sidelines in August and again held rates steady in September.
With activity in the US housing market hitting the skids, many financial market participants had begun to bet that policy-makers, who meet again on Tuesday and Wednesday, would soon begin to consider moving to buffer the economy.