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federal interest rates

The AM Call: Fed Delivers Hawkish Pause

  • For the first time in over a year, the Fed did not raise interest rates.
  • However, the official statement and press conference by Fed Chair Powell indicated that the Federal Open Market Committee (FOMC) could resume hikes at the July meeting.
  • Updated Summary of Economic Projections (SEP) delivered the hawkish surprise.

For the first time since this hiking cycle began in March 2022, the Fed held rates steady at a range of 5.00-5.25%. This marks a notable change in what has been the fastest rate cycle in decades. The pause was widely expected by markets, as the Fed had indicated that it was inclined to take a breather in the relentless pace of hikes it has delivered in the past 15 months.

The FOMC statement noted that “Recent indicators suggest that economic activity has continued to expand at a modest pace. Job gains have been robust in recent months, and the unemployment rate has remained low.”  The FOMC statement went on to say that “Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.”

In justifying its decision to pause at this meeting, the FOMC statement was clear: “Holding the target range steady at this meeting allows the Committee to assess additional information and its implications for monetary policy. In determining the extent of additional policy firming that may be appropriate to return inflation to 2% 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.” (emphasis added)

The hawkish surprise came in the Summary of Economic Projections, or SEP. The Fed updates its economic forecasts at every other FOMC meeting, or four times per year. The June SEP included upward revisions to the 2023 estimates for core Personal Consumption Expenditures, or core PCE, which is the Fed’s preferred inflation metric and, most importantly, to the median forecast for the Fed funds rate. The Fed is now expecting core PCE will end 2023 at 3.9%, still well above its 2% inflation target. As a result, the Fed funds rate is now projected to end 2023 at 5.6%, up from 5.1% in the March SEP.

This came as a surprise to markets, which had estimated that only one more +25 bps hike by the Fed. As well, the 2024 projections indicated a YE24 Fed funds rate of 4.6%, up from 4.3% in March. This caused markets to shift out their timeline for potential Fed rate cuts, indicating a bias for “higher for longer” rate policy. Whereas before the meeting, markets had estimated a better-than-even chance of at least one rate cut by the end of this year, futures markets are no longer pricing in any Fed cuts in 2023.

Following the Fed statement and press conference, equity markets were in the red, and short-end Treasury yields rose. At the same time, long end rates were relatively stable, indicating that markets believe the Fed’s focus on fighting inflation will ultimately be successful. These rate moves caused the yield curve inversion to regain momentum, with the 2s10s curve now -94 bps, once again approaching its March low of -108 bps, which was the highest curve inversion since 1981. While yield curve inversions are not always indicative of a coming recession, they have a good track record, and our base case view is that a recession is likely within the next 12 months.  The below chart shows the median forecasted proability of recession in the next twelve months from the latest economist surveys, submitted by banks and research provides, as conducted by Bloomberg:

Our takeaway view is that the Fed is in tough spot. They are cognizant of the impacts of such a dramatic pace of rate hikes, as evidence by the stress sin the banking sector which manifested this spring. They were also potentially wary of communicating a hike in the face of uncertainty around the debt ceiling debate. Although the debt ceiling issue was resolved in time, the Fed had already communicated a likely pause in hikes at its June meeting, and backtracking form this guidance would have caused market confusion. Furthermore, there are signs that the cumulative impact of Fed hikes are working as intended: initial jobless claims have risen for two weeks straight (although still very low) and May CPI came in pretty much as expected.

However, the economy overall remains healthy and with PCE inflation still well above target, the Fed’s job is not finished. Therefore, the Fed also wanted to signal that rates are going to be “higher for longer” to perhaps regain their inflation-fighting bona fides and keep markets on edge that they will keep hiking if the macro picture warrants further action.

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