The Fed raised rates by 25 bps. The Bank of England held steady. What’s next, and why is the Strait of Hormuz still calling the shots?

Hormuz Effect & Déjà vu - a phenomenon of feeling like you have experienced this situation before, even though you rationally understand: this is the first time it is happening. Usually, this feeling lasts only a few seconds and is accompanied by a strong sense of familiarity combined with a strange feeling of "wrongness" or anxiety — because you cannot recall when and where exactly this experience supposedly already took place.

And now, there is an impression that the problem (inflation) is being solved in the wrong office (the Fed), but it is hard to recall where we have seen this before.

Key points on yesterday's FOMC

Yesterday's Fed meeting was sharply "hawkish" from start to finish. The expected 25 basis point rate hike was accompanied by a dot plot that showed a strong consensus for one more hike by the end of the year. Of the 18 committee members, 12 priced in another hike, and four even priced in two. At the same time, forecasts for economic growth and inflation were revised upward, while those for unemployment were revised downward.

Fed Chair Kevin Warsh did not say much new at the press conference, but once again confirmed a firm commitment to price stability and did not imply that the current level of rates is restrictive for the economy. In his own words, the Fed has simply reduced the "dose of monetary easing."

Market Reaction

Even though the hawkish scenario was partially priced in beforehand, the two-year dollar swap rate still jumped 10-12 bps. The market is currently pricing in a 13 bps probability of a rate hike in October and 32 bps in December.

The dollar strengthened across the board: the DXY index rose 0.6% and hit a two-month high. There are several reasons for the continued elevated risk of dollar strengthening in the near future:

• October remains "in play": the Fed's tough tone effectively gives markets the freedom to fully price in the next move in October if the data comes in "hot" and/or oil prices continue to rise.
• Fed discipline raises the bar for the return of the so-called "debasement trade."
• Oil supports the dollar as an external factor as long as prices remain high.

The baseline scenario for the coming months is dollar stabilization within current ranges, and closer to the end of the year — a possible weakening, but this depends heavily on de-escalation in the Persian Gulf.

As for the yen, it is holding up better than other low-yield currencies after the Fed's decision — this may indicate market caution regarding short positions on the yen ahead of tomorrow's Bank of Japan decision.

Is the Fed hitting the right target?

It is worth admitting an uncomfortable truth here: raising rates is unlikely to cure the very thing currently driving inflation. The current rise in energy prices and the resulting higher inflation is not a consequence of money being too cheap, but a supply-side problem that the central bank simply has no levers to influence. More expensive credit will not add a single extra barrel to the market — it only stifles demand in an economy already lacking supply.

History shows that such a reaction often proves counterproductive: a significant portion of the damage after such price shocks usually comes not from the shock itself, but from an excessively harsh monetary policy response to it.

Therefore, the key question now is not how high inflation is today, but whether it is starting to take deeper root in the economy, or if it remains a mainly temporary consequence of the energy shock. If the latter, the rate will not hit the source of the problem, but rather interest-rate-sensitive sectors of the economy, slowing down investment and bringing closer the risk of layoffs, without making energy any cheaper.

The real challenge now is not to turn an energy problem into a full-blown credit crisis.

Long-term rate forecast

Despite the calm market reaction immediately after the decision, long-term rates will likely remain under pressure: a 25 bps hike does not significantly change the dynamic that has been weighing on long rates in recent months. Inflation remains high, as do the budget deficit and the volume of debt issuance, and the narrative about productivity growth thanks to AI has not gone anywhere. There is a risk that the yield on 10-year US Treasuries will rise above 5% again, and the market will begin to consider the 5.25–5.5% range as entirely achievable.

Bank of England decision summary

Thursday's Bank of England decision confirmed what was already understood: the prospect of a rate hike in November will depend entirely on energy prices.

The Bank of England voted 6 to 3 to keep the rate at 3.75%, but sent a clear signal: it is prepared to raise rates if energy prices remain high. The baseline scenario is to hold the rate, provided that energy prices decrease within the next six weeks. If this does not happen, the Bank will likely reluctantly raise the rate in November, and possibly in February.

It is noteworthy that the Bank now expects inflation to peak slightly above 4% at the beginning of next year. The reason is clear: if natural gas prices remain at current levels, a rise in the energy price cap for households of approximately 25% can be expected in January.

This is important because the Bank of England's previous research shows that when inflation exceeds 4%, the probability of second-round effects increases. Deputy Governor Sarah Breeden, who voted to hold the rate, noted that inflation is approaching "levels associated with non-linear effects."

At the same time, there are no signs yet that the rise in fuel and energy prices for households is spreading to other categories of the consumer basket. Inflation for energy-intensive goods and services has even decreased this year, and food inflation is declining — which contradicts expectations.

Unlike the US or even the Eurozone, where there is a lively debate about whether current rates are restrictive, in the UK this argument is much weaker: the labor market is weaker, fiscal policy is tighter, and interest-rate-sensitive sectors are under more pressure. Most of those who voted to hold the rate emphasized that financial conditions are already curbing economic activity right now — in contrast to Warsh at the Fed, who spoke of "reducing the dose of easing."

Therefore, if the Bank of England does raise the rate, it will be more of an "insurance" hike for risk management purposes, rather than a reaction to the economic data of the next six weeks. Market expectations for four rate hikes over the next year look exaggerated.