A Larger-Than-Normal Fed Rate Hike in December Now Looks More Likely. Here's Why.

When it raises interest rates to fight inflation, the Federal Reserve typically moves very gradually, hiking its target rate by a quarter of a percentage point at a time.

But December may be different. That's because, after raising the federal funds rate by a quarter of a percentage point at its September meeting, the Fed's monetary policy committee paused in October to see if inflation was beginning to cool.

Suddenly, it looks like that was a poor decision. The Consumer Price Index (CPI), the main measure of inflation in the U.S., was just published and showed that inflation was higher than expected in October. The overall price level rose 0.4% month over month, higher than the 0.3% expected and well above the 0.2% level the Fed would like to see.

Higher energy prices, related to the ongoing conflict with Iran, continued to add to overall inflation. But other sectors saw larger-than-expected increases, too, including housing.

The Fed may have to play catch-up in December

As a result, the Fed may have to play catch-up at its last meeting of the year, on Dec. 8-9. That means it could move from its typical quarter-point hike to a half-point hike, which could be jarring for financial markets unused to larger rate increases.

In fact, one Fed official said it out loud. Fed Governor Christopher Waller said on Nov. 10 in a speech in London that a 50-basis-point (bp) hike -- equivalent to half of a percentage point -- is merited. If October's core CPI rate (the rate that excludes volatile food and fuel costs) came in at 0.3% or higher, he said, "I believe a 50-basis-point hike in the policy rate should be considered at the December meeting." And indeed, core CPI in October was 0.3%.

Image source: Official Federal Reserve Photo.

It's not yet clear that Fed Chair Kevin Warsh is on board with a 50 bp hike in December, and we may get little indication of how he's leaning before that meeting, as he has come out against giving markets hints of what he's thinking.

But I think he'll be won over to a larger hike. Despite not hiking the federal funds rate in October, Warsh sounded very hawkish at his press conference after the October meeting, and with the economy and the labor market appearing very healthy at the moment, he may reason that a larger rate hike won't harm them much.

Right now, futures traders are pricing in an 87% chance of a quarter-point hike and a 13% chance of a half-point hike. But I believe that will change in the coming weeks. The next key data point to watch is the Personal Consumption Expenditures price index, which will be published on Nov. 25.

If that index, like the CPI, comes in hotter than expected, I expect a half-point hike in December.

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