By Howard Schneider
WASHINGTON (Reuters) - The Federal Reserve will conclude its last policy meeting of the year on Wednesday on the back of a surprise drop in inflation, consensus around a slowed pace of interest rate increases, and markets primed for a coming halt in the monetary tightening.
Fed officials signaled in recent weeks that they would raise the U.S. central bank's benchmark overnight interest rate by half a percentage point at their two-day meeting this week, scaling back from four straight three-quarters-of-a-percentage-point increases, in an acknowledgement that rates were approaching the level needed to slow the economy and lower inflation.
Graphic: Rates and inflation Rates and inflation, https://www.reuters.com/graphics/USA-FED/INFLATION/gkvlgnaywpb/chart.png Along with the latest policy statement, which is scheduled to be released at 2 p.m. EST (1900 GMT), officials will issue new projections showing just how close that endpoint may be, with the release on Tuesday of market-friendly inflation data for November triggering bets across stock and bond markets that it may be closer than expected.
After the anticipated half-percentage-point increase on Wednesday, the target federal funds rate would be set in the 4.25%-4.50% range. Investors in contracts tied to the federal funds rate now see the Fed scaling back to quarter-percentage-point hikes in February and March, leaving the policy rate just shy of 5% at the stopping point.
The November inflation data, which showed consumer prices rising less than expected for a second straight month, "increases the likelihood that we could get a dovish surprise" from new policymaker projections showing rates rising only another half percentage point by the end of 2023, Krishna Guha, vice chair of Evercore ISI, wrote ahead of the policy decision. Guha, however, said he still expects Fed policymakers' median rate projection to narrowly favor a higher endpoint in a range from 5% to 5.25%.
Fed Chair Jerome Powell will hold a news conference at 2:30 p.m. to elaborate on the policy decision and give more details on what might happen in coming meetings.
The focus is likely to be less on the day's rate decision than fresh economic projections that will mark a new phase in the Fed's policy debate. With an interest rate peak in view, the new projections will show both the progress expected on inflation over the year, and the cost that higher interest rates may exact in terms of rising unemployment and slower economic growth - tradeoffs that could begin to stress the Fed's current policy consensus.
"The first half of 2023, that is clearly the discussion" as policymakers weigh the federal funds rate needed to secure "the last mile of inflation" control against potential job losses, said Joe Davis, global chief economist at Vanguard.
"The labor market will be the swing factor," as officials analyze if wage and job gains slow in coming months, Davis said. Powell has said some cooling in the currently hot job market will be an important sign the economy is heading towards consistently lower inflation.
Policymakers have been caught off guard through much of this year by higher-than-expected price increases, particularly in June when new data released just ahead of a Fed policy meeting showed prices accelerating. That prompted policymakers to rally around faster rate hikes.
Graphic: The Fed's view of 2022, https://www.reuters.com/graphics/USA-FED/PROJECTIONS/klpygggbapg/chart.png They may now face the reverse problem if inflation begins a faster-than-expected fall.
The Consumer Price Index (CPI) continues to rise fast, increasing in November by 7.1% on an annual basis. But that is down from June's rate of 9%, which was the highest in four decades.
The month-to-month pace of inflation has slowed even more markedly.
Excluding volatile food and energy prices, so-called "core" inflation over the last three months has been around 4% on an annualized basis, "within spitting distance" of where the Fed wants to head, Wendy Edelberg, a senior fellow at the Brookings Institution, said in a web presentation on Twitter on Tuesday. "We are close to the end of this tightening cycle."
The Fed targets 2% inflation using a different measure that is equivalent to consumer price inflation of around 2.5%.
Given the inflation surprises of the past year, Powell has been reluctant to declare an end to the inflation battle, insisting that any given month's change would not be convincing until a trend was clear.
But having "front-loaded" the fastest shift in monetary policy in 40 years without causing either a major calamity in financial markets or a significant rise in the unemployment rate, Fed officials have also agreed to move more carefully from this point in order to avoid stressing the economy too much.
In his last public remarks before this week's meeting, Powell sketched out both why he was concerned that inflation may remain elevated for some time to come, and his desire not to "overtighten" and steer the economy into a recession.
The November CPI report should give policymakers some confidence that data may finally be moving in their favor.
Within the core group of goods and services, shelter is now fueling overall price increases, Inflation Insights President Omair Sharif wrote. With monthly apartment rents in decline, headline shelter inflation should over time begin to slow as well.
November's report "is not an outlier ... (it) showed a fairly broad-based slowdown," Sharif said.
(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)Click Here To Get Funded!