Fed is Expected to Pause Rate Hikes, But Stubborn Inflation Could Make the Break Brief

The Federal Reserve is expected to leave interest rates unchanged this week, offering borrowers a reprieve after September's increase. But with inflation gathering momentum and the economy showing few signs of weakening, another hike could follow before policymakers are ready to declare their work finished.

Investors assigned a 90% probability to the Fed holding its benchmark rate at 3.75% to 4.00% at its October 27-28 meeting, according to the CME Group's FedWatch tool. That confidence reflects signals from officials that they can afford to wait, particularly after rising Treasury yields pushed borrowing costs higher across the economy.

The expected pause, however, comes ahead of government reports that could strengthen the argument for further tightening. Data scheduled for Thursday are projected to show faster inflation in September and stronger economic growth in the third quarter, supported by consumer spending and business investment tied to artificial intelligence.

Economists expect the annual increase in the personal consumption expenditures price index, the Fed's preferred inflation measure, to reach 3.6%, up from 3.4% in August. Higher gasoline prices linked to the conflicts in the Middle East account for part of that acceleration, but price pressures have also spread to airfares, rents and computers.

That broader increase complicates the Fed's effort to bring inflation back to its 2% target. However, September's unemployment rate stood at 4.2%, while weekly applications for unemployment benefits remained exceptionally low.

The main reason to wait lies in the bond market. After September's rate hike, the yield on the 10-year Treasury climbed toward its highest levels in nearly 25 years, threatening to restrain activity more sharply than officials intended.

Higher Treasury yields can raise financing costs for households and businesses, effectively doing some of the Fed's work. New York Fed President John Williams and Fed Vice Chair Philip Jefferson subsequently indicated that policymakers could wait for additional evidence before deciding their next move.

But that rationale became less straightforward late last week, when bond yields retreated during a stock selloff driven by concerns about the sustainability of AI demand. An easing in financial conditions could weaken the case for an extended pause.

Fed Chair Kevin Warsh also faces a sensitive communications test days before the November 3 midterm elections. Voters' concerns about affordability encompass both persistent inflation and the higher interest rates intended to contain it.