Fed Expected to Pause Rate Hikes in October, But Persistent Inflation and Energy Prices Increase Risk of December Hike

What happened

The Federal Open Market Committee (FOMC) of the Federal Reserve (Fed) is expected to keep the benchmark interest rate in the United States unchanged at 3.75% to 4.00% at its meeting this Wednesday (28). This pause in the monetary tightening cycle is seen as strategic, allowing the Fed to assess the impact of already implemented financial restrictions without ruling out a further hike in December. The decision reflects an internal consensus to alternate interest rate increases, with 90.6% of the financial market, according to the CME Group's FedWatch tool, betting on stable rates. The proximity of the midterm elections may also discourage bold moves, as noted by Vinicius Flores of Stratton Capital New York. Despite the pause, the American economy shows resilience, and inflation persists, revived by oil prices and spreading to other sectors. Goldman Sachs observes that the FOMC's strategy has been to raise rates every other meeting, which would justify the October pause and a potential increase in December.

Why it matters

The Fed's rate maintenance in October, followed by the expectation of a new hike in December, signals that American rates may remain elevated for longer. This scenario is crucial for Brazil, as a smaller interest rate differential between the Selic and US rates tends to pressure the exchange rate, making the real less attractive to investors seeking yield. Furthermore, persistent inflation in the US, driven by supply shocks such as energy prices and spreading to other items like rent and services, complicates the Fed's task of balancing a slowing labor market with inflation control. For the Copom, this more restrictive external environment, coupled with post-election fiscal stress in Brazil, may reduce the room for more aggressive Selic cuts, directly impacting domestic monetary policy and the cost of credit.

Market impact

Interest rates and bonds: US Treasury yields are likely to remain elevated or rise, especially for shorter maturities, reflecting the expectation of higher rates for longer in the US. In Brazil, future interest rates may rise, as lower expectations for Selic cuts, or even the possibility of maintenance, price in a tighter monetary policy scenario. Dollar and exchange rates: The dollar tends to strengthen globally, including against the real. A smaller interest rate differential between Brazil and the US reduces the real's appeal for capital flows seeking carry trade, exerting downward pressure on the Brazilian currency. Equities: Stock markets, both in the US and Brazil, may face volatility. Higher interest rates in the US tend to make credit more expensive and reduce the attractiveness of risk assets, potentially leading to a correction. In Brazil, exchange rate pressure and lower prospects for Selic cuts may also weigh on the Ibovespa. Commodities: Commodity prices, especially oil, are already being driven by geopolitical shocks. The persistence of this inflationary pressure could keep prices elevated, which is a risk factor for global inflation and central bank decisions. Brazil: The external scenario of higher US interest rates for longer, combined with persistent inflation and domestic fiscal stress, tends to limit the Copom's room for Selic cuts. This could result in a higher domestic interest rate for an extended period, impacting economic growth and the cost of public and private debt.

What to watch

Upcoming inflation data (CPI and PCE) and labor market reports (payroll) in the US will be crucial to confirm or invalidate the reading of a temporary pause followed by further tightening. Comments from FOMC members will also be closely monitored for signals about the future direction of monetary policy. In Brazil, the evolution of the post-election fiscal scenario and upcoming domestic inflation data will be fundamental for the Copom's decision on the Selic.

Scenarios

Base Scenario: The Fed maintains rates in October but raises them in December due to persistent inflation. This restricts the room for Selic cuts in Brazil, keeping domestic interest rates high and pressuring the exchange rate. Risk Scenario: US inflation decelerates faster than expected, or the labor market weakens significantly, leading the Fed to signal the end of the tightening cycle. This would open more room for the Copom to cut the Selic and alleviate pressure on the real. Original source: InfoMoney. For information only, not investment advice.