By Ann Saphir
July 29 (Reuters) - As the clock ticked toward the U.S. Federal Reserve's interest rate decision announcement on Wednesday afternoon, financial markets held their collective, metaphorical breath: Will they, or won't they?
Typically, well before the morning of a Fed rate decision day, prices for interest rate futures contracts reflect settled wisdom about the central bank's choice in light of the economic data, and are usually well-telegraphed by policymakers themselves. Fed Chairman Kevin
Warsh, however, has given nothing away about his views on the appropriate rate path.
On Wednesday, rate-futures bets implied about a 65% chance that policymakers will hold short-term rates steady and a 35% chance they will hike, reflecting the greatest level of uncertainty around a Fed rate decision in years.
Here's a look at some of the reasoning for each.
THE CASE FOR A HIKE
Inflation, as Warsh has himself noted repeatedly, has been running above the U.S. central bank's 2% target for more than five years. The year-over-year change in the Personal Consumption Expenditures Price Index, which the Fed uses for that goalpost, accelerated this year as the U.S.-Israeli war with Iran drove up oil prices and as services inflation — which is not directly tied to fuel prices or to goods prices that had risen because of tariffs — stayed high and broadened. In May, the most recent reading available, PCE inflation was 4.1% on a year-over-year basis.
And while persistently high inflation is not crushing the consumer, whose spending has held up despite broadly higher prices, it does run the risk of feeding expectations that price pressures will remain strong, potentially triggering a self-fulfilling cycle.
Meanwhile, the labor market has remained stable, with unemployment at 4.2% in June. It does not require the support that holding rates steady would offer.
Without a rate hike to tamp down on demand and signal the Fed's determination to rein in price pressures, inflation will remain too high. Warsh has said he has "no tolerance" for inflation that has been running above the central bank's 2% target for more than five years. Raising borrowing costs would show that the time has come to deliver on that promise.
WHY THE FED SHOULD HOLD RATES STEADY
Inflation is too high, but it won't stay there because the main drivers of price pressures will soon fade or are already doing so.
The impact of last year's tariffs is already fading, and goods price pressures are expected to continue to fall. The outcome of the Iran war is uncertain, but oil prices have come down from their peak even without a secure ceasefire. Housing, one sector of the economy that has certainly felt the impact of higher borrowing costs, is contributing less to inflation than it had been.
The 3.5% year-over-year rise in the Consumer Price Index in June — CPI is not the Fed's benchmark measure but an important gauge of price pressures nonetheless — was down considerably from May's 4.2% reading, and there will be two more readings between now and the Fed's September 15-16 meeting to check whether that trend continues and, even more importantly, whether underlying pressures, as measured by stripping out food and fuel prices, also fade.
Meanwhile, the labor market is stable and is not adding to inflationary pressures, but the low-hire, low-fire employment environment suggests fragility to a potential shock, including from a rate hike that might be understood as the beginning of a series of increases rather than an isolated event.
The White House has made it clear that it expects lower, not higher, borrowing costs from the Warsh-led Fed, and while central bank policymakers say they do not consider politics when making decisions, hiking in the face of recently retreating inflation and a case for further improvements could prove problematic.
Lastly, the risks of a hike for now may not outweigh the benefits, and the Fed can always increase rates in September should the need for it become clearer by then.
(Reporting by Ann Saphir; Editing by Paul Simao)
