The US economy and the Fed seem to be moving in opposite directions - and it can't last

Something funny happened at the September Federal Reserve meeting: Policymakers' resolve to keep hiking interest rates appeared to rise even as their own forecasts pointed to subdued economic growth and inflation that will continue to undershoot the Fed's 2% goal.

After its two day-meeting, the central bank announced it was holding interest rates steady for now and that it will start gradually reducing its $4.5 trillion balance sheet next month.

But, another thing happened that is grabbing the attention of traders in financial markets. According to the Fed's own interest rate projections, also referred to as the dot plot (seen below), only four officials do not see the central bank hiking rates later this year.

Federal Reserve

That conflicted with market expectations for a December hike, which had been declining in the face of weak inflation figures and the expectation that the hit to growth from a series of destructive hurricanes might lead the Fed to pause a while longer.

"The Fed is going to raise rates again in December," wrote Andrew Brenner, head of global fixed income at National Alliance Capital Markets, in an email to clients. "Odds are about 2 to 1 for a raise, which is dramatically different from a few weeks ago when it was 5 to 1 against."

Futures markets are now pointing to a 60.5% chance of a December rate increase, according to Bloomberg's World Interest Rate Probability data. This is happening as inflation data not only undershoots the Fed's inflation target but continues to drift downward.

Brenner believes the market's hawkish sentiment will shift as the reality of economic weakness sets in. For instance, the Atlanta Fed recently revised its third-quarter growth forecast from 3% to 2.2%.

"The only thing that has happened since then has been multiple hurricanes," hed said. "We don't think that is enough to get markets to believe a Fed tightening for December, which is why we think the tightening mood will be transitory."

Atlanta Fed

Moreover, Trump's surprise debt ceiling deal with Democrats makes it a strong possibility that the United States could be facing a government shutdown in December, perhaps not the best time for a monetary tightening.

Still, officials seem to be prepping markets for the possibility of a rate increase should they view one as necessary.

"This gives the Fed plenty of leeway to move forward with a hike at that point without unsettling the markets," Karissa McDonough, chief fixed income strategist at People's United Bank, said in a note.

As highlighted during Fed Chair Janet Yellen's press conference with reporters, the outlook for Fed policy is especially uncertain given the large amount of looming turnover at the central bank. This includes a likely replacement of Yellen as Fed chair.

"Something important to watch is for clues on Fed policy continuity in a year where the chair and several additional members may transition off the committee," McDonough said. "If this is the case this may argue for a change in outlook in terms of our bias for the Fed to be cautiously moving on tightening policy."