Of course, no one really knows the answer to this question and only time will tell. However, one major source of market anxiety and frustration all year, interest rate hikes from the Federal Reserve, may soon be drawing to a close. When we talk about the Fed it’s always a tale of two birds, the hawks raising rates or holding them high to combat inflation, and the doves lowering rates or holding them low to stimulate the economy. The Federal Open Market Committee (FOMC) met on Wednesday so today we’ll look at the interest rate decision and see which birds we can spot this month.
Amid a slew of economic data and corporate earnings this week the Federal Reserve announced its interest rate decision. On Wednesday the FOMC unanimously decided to raise interest rates by 0.25% bringing the Federal Funds rate range to 5.25% – 5.50%. This was largely expected by the market. However, after a pause in rate hikes in June and with inflation falling steadily, the next question is if the hike this week was the last of this cycle. At the beginning of the year decision makers on the FOMC were all staunchly hawkish, meaning there was little uncertainty of continuing rate hikes, but market participants are beginning to ask if enough is enough.
The press release and comments from Fed Chair Jerome Powell after the interest rate decision didn’t show a change in outlook. The language in the press release was, “In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, 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.” This is the same language from the June press release which seems to confirm that the outlook is the same. We will have a clearer picture of the stance of various committee members with the release of the Summary of Economic Projections (SEP) in September which will show how many committee members favor interest rates at a particular level by year-end. As of the June meeting SEP only a third of committee members favored rates peaking at 5.50% or lower, but over 80% expected rates at or below 5.75%. (see image below) Working from that data and the tone of the press conference, it would be reasonable to expect another quarter-point rate hike by year-end. However, should inflation continue to abate, those committee members will also have more data showing cooling inflation and less of a reason to continue hiking rates, and market participants are already betting another hike won’t materialize.
The Fed’s June “Dot Plot”
With all the talk of inflation for more than a year, it can sometimes get lost in the news that inflation is not the only factor the FOMC considers. The Fed has a dual mandate of price stability (read low and predictable inflation) and maximum employment (read low unemployment) and in the current fight against inflation, these factors are somewhat at odds. Unemployment is certainly low at 3.6%, just a hair’s breadth from a 50-year low of 3.4% earlier this year. One box checked. However, the Fed has an inflation target of 2%, and all measures they examine are still above that target. As of the most recent readings, both the CPI and Personal Consumption Expenditures (PCE) year-over-year change (YoY) were at 2.97%. These are two different ways of measuring the change in the cost of living. That seems quite close to target, but the Fed also considers the “core” version of these measures which removes the more volatile food and energy prices from the figures. To understand why we might want to consider core CPI and core PCE, just think about how much and how quickly the price of gas has changed in the last year each time you’ve visited the pump. That kind of fluctuation can affect the numbers, but we can’t expect low prices to stick around. The most recent readings of Core CPI YoY and Core PCE YoY were 4.86% and 4.10% respectively, which is well above the Fed target. Powell commented that while CPI is reflective of what American consumers’ experience of inflation is and it is good to see CPI below 3%, core data is more reflective of where CPI will likely go given the volatility of food and energy prices and they view core PCE and core CPI as being rather high.
What’s interesting is that this 2% target the Fed is aiming at has only been in place since January 2012.1 It could be argued that there was an implicit 2% target for some years before it became official, but it isn’t as though the US has always been at 2% inflation. That might lead one to wonder if 2% is empirically better for economic stability than say 3% inflation and whether it is worth increasing risks of weakening employment to get to that target. Indeed, Powell was asked this question during the press conference and his response was that the goal is not to create weaker employment, but inflation is still the bigger risk and he acknowledged that continued policy firming may impact employment (meaning increase the unemployment rate). So, it appears that the potential for weaker employment numbers is not swaying the resolve of the FOMC to combat inflation, or at least that is what they are saying.
Measures of US Inflation 1973 – Present
By all measures inflation is falling but remains above target (horizontal green line represents Fed 2% target, grey bars represent recessions).
So, if we are to take the Fed Chairman at his word, the Fed seems to remain hawkish for now, and it may be some time before doves appear. Perhaps some committee members will become less hawkish and be content with holding rates high rather than continuing to raise them. Powell left the door open to this possibility, but without providing any real guidance to help set expectations. He said the committee will make decisions “meeting-by-meeting” and, to paraphrase, “it’s certainly possible that the committee could raise rates again or hold steady at the September meeting.” The FOMC may become less unified as inflation gets closer to the 2% target. While the risk of further rate increases is not verifiably out of the equation yet, growth seems to be steady, and employment remains strong. So, is it the best of times or the worst of times? For workers it’s pretty good, with unemployment low and real wage growth positive. For consumers it’s getting better, with prices rising less rapidly as inflation cools. For corporations, we had more positive earnings surprises than negative ones this week. As a broader measure of the economy, we had a strong GDP advanced report of 2.4% for 2Q23. There are reasons to be optimistic. But a hawkish Fed could still pose a risk to strong employment and those negative indicators are still flashing red. The indicators could be wrong this time, but perhaps cautious optimism is warranted.
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