Written by: Zhao Ying, Wall Street Journal

The Federal Reserve's decision tonight is likely to be "hold steady," but what the market is truly concerned about is not the baseline scenario, but rather a rare unexpected rate hike or a sufficiently hawkish pause in its wording.

At 2:00 AM Beijing time on July 30, the Federal Reserve will announce the latest interest rate decision. This meeting will not include a dot plot or updates to economic forecasts, with the target range for the federal funds rate expected to remain at 3.50%-3.75%. According to a Reuters survey, all 104 respondents predict no change in rates. However, the money market still indicates about a 32% probability of a rate hike this week and incorporates around 42 basis points of tightening for the year, making tonight's meeting the most uncertain in recent years.

The uncertainty arises from the tug between two forces. June CPI fell short of expectations, non-farm employment was weaker than anticipated, and oil prices declined before the meeting, all providing room for the Fed to wait. However, inflation remains above target, the situation in the Middle East and oil prices fluctuate, some Federal Reserve officials have recently leaned hawkish, 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 that he feels an unprecedented level of uncertainty about the upcoming Federal Reserve decision—it's the most uncertain he's felt in 20 years, with the last similar instance being right after Bernanke took over as Fed Chairman. "Waller will lead the policy direction in the coming meetings, and we know almost nothing about his views on monetary policy."

For investors, the risks are concentrated in 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 raised by 50 basis points, the decline could expand to 2%-4%. Even if rates remain unchanged, any hawkish tone in the statement or press conference may limit the rebound in risk assets.

The market consensus is to pause, but pricing is not calm

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

However, the same survey indicates that 66% of respondents believe there is a "high" likelihood of a rate hike this year, which is markedly different from the "low" mainstream judgment in June. Market pricing also shows that investors are paying for tail risks of rate hikes. Traders are currently assigning about a 30% probability of a rate hike this week and fully pricing in a 25 basis points hike before September, as well as close to a 50 basis points increase before March of next year.

Goldman Sachs believes this pricing suggests 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 would quickly reevaluate the previously priced in rate hike risks. Ian Lyngen of BMO Capital Markets noted that since 2015, traders have averaged just a 2.4 basis points error in predicting the final rate decision before Federal Reserve meetings, but this time the market is more prone to a sharper immediate reaction than usual.

Data support waiting, but inflation risks remain

The rationale for the Federal Reserve's pause primarily comes from the latest data. June CPI fell below expectations, weakening prior rate hike bets triggered by hawkish comments from Waller. Waller indicated that if June's core CPI were hot, a rate hike should be considered; if the data were cool, he would need to see more similar readings to regard them as a clear signal.

The labor market also gives the Federal Reserve more observation time. June's non-farm employment was weaker than expected, with the previous value revised down, resulting in a net reduction of 74,000 jobs over two months, changing from an increase of 93,000 jobs previously. Although the unemployment rate slightly decreased, the data suggests this may primarily stem from a decrease in the overall labor participation rate.

Oil prices are also a key variable. The conflict between the U.S. and Iran escalated after the previous meeting, with the related memorandum of understanding being violated and both sides resuming strikes. However, during the weekend before the meeting, strikes were paused, geopolitical risk premiums declined, and oil prices fell, helping to ease inflation expectations. Federal Reserve officials had also previously warned against responding too quickly to what might only be temporary supply shocks.

The issue is that underlying inflation still remains clearly above target. Morgan Stanley pointed out that upward risks include persistently high oil prices, the Federal Reserve's reaction function becoming more hawkish, and AI-driven investment pushing up neutral rates. Goldman Sachs also believes that the combined effects of tariffs, war, and AI statistical errors on monthly inflation may weaken in the future, but uncertainty remains significant; if inflation improvement is interrupted, discussions within the Federal Reserve about rate hikes will reheat.

The communication era of Waller itself is a risk

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

Morgan Stanley expects that this statement will likely remain unchanged, including reiterating the "adequate reserves" policy, describing economic activity as continuing to "expand at a moderate pace" under high uncertainty, with unemployment "not changing much," and inflation still "high." Since there is no economic forecast summary this month, policymakers have no 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 chairman's working group, and whether the latest data will advance the policy action timetable. Goldman Sachs anticipates that Waller will not provide a clear policy signal, possibly emphasizing that all options remain open and future decisions depend on the data.

Credit Agricole believes that the Federal Reserve is entering a new phase with limited forward guidance, which will turn more meetings into true "live meetings." The bank expects the Federal Reserve will still hold steady this time and believes the data since the last meeting has at least bought time for continued pauses. Regarding the five working groups newly established by Waller, Credit Agricole does not anticipate 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 balance sheet policies are unlikely to change temporarily.

Divisions broaden, a pause may also accompany dissent, focus on opposing votes

The divisions within the Federal Reserve are at the core of this meeting's uncertainty. In June’s forecasts, of the 18 participants who submitted forecasts, 9 expected at least one rate hike this year. Subsequently, statements from multiple officials indicated that if inflation stalls, they would be willing to consider further tightening.

Waller and Cook both stated that if the anti-inflation process stalls, tightening could be considered. Voting committee members Logan and Hammack in 2026 have expressed more hawkish views. Logan argued that policy rates should be moderately higher to better balance prospects and risks, asserting 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 upside inflation risks brought by geopolitical conflicts and that there may be at least one committee member voting in support 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 noted that if the market does not rule out the risk of a rate hike, strategists will not exclude it either.

A few institutions bet on a rate hike "shock"

Although the mainstream view remains to pause, some institutions are clearly betting on an unexpected rate hike. Citadel Securities stands out as a significant exception, with its macro strategy head Frank Flight changing the baseline scenario this week to a 25 basis points rate hike. He believes this will bolster Waller's credibility in combating inflation and "clearly end the era of forward guidance."

PGIM Global Bond Head 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 a decision is delayed now, it may increase the odds of a 50 basis points rate hike in September.

Wrightson ICAP Chief Economist Lou Crandall asserted that the Federal Reserve lacks sufficient reasons to not raise rates. Veteran bond market participant Harley Bassman even argued that the Federal Reserve should raise rates by 50 basis points all at once to strengthen its anti-inflation credibility.

However, Goldman Sachs still believes that most voting members 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 creating 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: A rate hike is the biggest shock, a hawkish pause is also not easy

JPMorgan Market Intel lists a "hawkish pause" as the baseline scenario, with a probability of 50%. In this scenario, the S&P 500 index could rise by 0.25% to drop by 0.50%. The logic is that the Federal Reserve will pause due to the resilience of the labor market and growth while continuing 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 seeing larger declines. If rates are raised by 50 basis points, the S&P 500 index could drop by 2%-4%. In the case of a "dovish pause," meaning rates remain unchanged and communication is eased, the S&P 500 index could rise by 0.50%-1%. In the options market, options expiring on July 29 are pricing in about 0.8% volatility for the S&P 500, lower than the recent CPI event of about 1.1% pricing.

In the forex market, 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 keeps rates unchanged as expected by its economists, it could exert moderate but controllable pressure on the dollar against G10 currencies.

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

In the commodities market, Goldman Sachs' crude oil trading desk stated that oil risk premiums are quickly declining due to the U.S. and Iran forming a de facto ceasefire over the weekend and negotiations for reopening the Strait of Hormuz advancing. However, upward risks have not disappeared; if attacks against Saudi oil facilities or production continue, oil prices may rise again. Gold has fluctuated within about $250 over the past two months, and the trading desk maintains a long-term bullish outlook but tends to trade tactically around news events.

This means that tonight the key is not just whether interest rates change, but how Waller interprets "staying the same" or "changing." 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.