Today, the Federal Reserve (Fed) followed through on a widely expected fourth consecutive 75 bps rate hike, sending the Fed funds rate up to 3.75-4%.
At the press conference, Fed chair Jerome Powell signaled the possibility of slower hiking in the future, while maintaining optionality and data dependency ahead of the December meeting; “slowing time is coming—maybe at the next meeting, or the one after that,” but also that it is “premature to be thinking about pausing.”
The FOMC statement included subtle acknowledgement of prior tightening and lagged economic effects’ impact on the future policy rate path: “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
Powell continued to reiterate that there is still “ground left to cover from here,” and that the Fed will “stay the course until the job is done.”
Markets have been recently ratcheting up their policy rate expectations in preparation for today’s FOMC statement. Given recent hot inflation prints, a 75 bps rate hike was all but certain. Today’s policy statement, however, also included acknowledgment that a restrictive policy path will not only address elevated and problematic inflation, but also must account for “cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” While this appears subtle, it is the first policy statement since rate hikes began this year to acknowledge the impact of prior rate hikes, as well as their lagged effects. Nonetheless, price stability remains the Fed’s overriding priority and, therefore, policy rates must continue to be raised to a level that will be “sufficiently restrictive to return inflation to 2%.”
Recent market expectations
Since the last FOMC meeting, modest declines in August labor demand initially prompted markets to reduce their rate expectations. However, moves on this data were subsequently reversed following better-than-expected job additions, hotter CPI, and persistent wage inflation data for September.Since the end of 2Q22, markets had raised their peak policy rate expectations (peaking in June 2023) from 3.18% in early August to over 5.04% this morning. However, today’s statement initially dropped this to below 4.90%, only to recover during the press conference and Q&A, and finally close above 5.07%. Chair Powell’s comments today that the terminal rate may be higher than they envisioned at the last meeting in September bolstered investor expectations that it could be around 5%. This reduced the initial statement interpretation of a down-shift. However, markets continue to expect rate cuts to begin in 3Q23.
Outlook for the pace of policy
Of even greater nuance to the widely expected rate hike today, was discussion, in both the official statement and at the press conference, around language changes that could indicate a slowing of future rate hikes.
While maintaining optionality for the December meeting, the released statement acknowledged the tightening of financial conditions already experienced from the now four consecutive 75 bps rate hikes this year. Recognition of the outside lag with respect to prior rate hikes, and their effects on economic activity as well as inflation, was an important development in the statement, and goes some way to conceding the growth and stability risks that come with tighter monetary policy. This was interpreted by markets as opening the door to a slower pace of rate hikes, and markets initially rallied on this linguistic development in the statement. Chair Powell stated that policy rate hike “slowing time is coming— maybe at the next meeting, or the one after that.”
However, to prevent any suggestion of a future slowdown of the pace of rate hikes being misinterpreted by markets as a wholesale “dovish pivot,” in the press conference Chair Powell emphasized his belief that it remains “premature to be pausing.”
Powell’s message for the medium-term path was far clearer: “Restoring price stability is essential” that reducing inflation will require “a sustained period of below-trend growth,” and that it will take some time and require taking further “forceful steps.” The initial risk rally off the statement dissipated during the press conference on the back of Powell’s more balanced and clearer presentation of FOMC views.
Economy and inflation
Although inflation has likely peaked, price pressures will only fade slowly, and labor market tightness continues to imply that wage pressures remain potent. Powell acknowledged that the latest Employment Cost Index release, albeit mixed in parts, had not been a welcome development, and also pointed out that the FOMC needs to see a convincing run of weakening inflation data before they can be confident that inflation is moving back towards target. While some economic data has been softer in recent weeks, Powell continues to consider the U.S. economy fundamentally strong and that the labor market, while softening in places, remains extremely tight. The continued strength of the U.S. economy is something that the Fed will need to curtail to tame inflation.
Policy and market outlook
Powell’s remarks should remind markets that the current inflationary environment cannot permit the Fed to suspend its rate hike path, and it must remain data dependent ahead of future FOMC meetings. The message remains clear that the Fed “has a way to go,” and it is “premature to be thinking about pausing.” Despite initially being well-received by markets, Chair Powell reiterated the Fed’s “overarching focus” remains inflation.
In contrast to market expectations of rate cuts in 2H23, our own expectations are more restrictive, given that the Fed has stated that once the “policy rate had reached a sufficiently restrictive level, it likely would be appropriate to maintain that level for some time.” With the Fed’s continued focus on delivering price stability, irrespective of the resulting economic pain, a maintained restrictive stance will be necessary into 2023 to achieve these goals.
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