No change from the Fed, but higher for longer is the clear message
The Federal Reserve certainly delivered a hawkish pause today with the message clearly being that policymakers believe interest rates will be staying higher for longer. The Fed still have one 25bp hike in their summary of economic projections for this year with 12 FOMC members backing the move while seven look for stable policy rates through to year-end. However, they have upped the view for next year so there are only 50bp of rate cuts pencilled in rather than the 100bp that was viewed as the most likely outcome back in June.
Individual Fed member forecasts for changes to Fed funds target range from current 5.25-5.5%
June predictions in parentheses
Fed expects inflation to return to target with recession avoided
Text changes include the description for activity as “expanding at a solid pace” reflecting the recent strength in activity data, having described it as expanding at a “modest pace” in July. Fourth quarter year-on-year growth has been revised up for this year to 2.1% from 1% while for next year it is up to 1.5% from 1.1%. The unemployment rate has also been forecast lower to 3.8% from 4.1% for year-end while for next year it is 4.1% from 4.5%. As the table below shows, there is little change to their view that inflation will gradually return to target.
Fed official central projection versus their June predictions
These are major changes, suggesting that officials are firmly of the view they can generate a soft landing/no recession while guiding inflation towards the 2% target over time. This is a bold call given all the uncertainties out there and makes it appear more likely that the Fed will indeed carry through with another hike even though we don’t think it is necessary. Markets appear to be somewhat sceptical as well, only pricing 8bp of a 25bp hike in November and a cumulative 13bp by December versus 7bp and 11bp ahead of the meeting.
Intensifying headwinds means a lower profile for Fed funds remains our call
The Fed is indicating it thinks it needs to do more and will have to keep policy tighter for longer to ensure inflation returns to 2% on a sustainable basis. However, this will be contingent on ongoing strength in activity, inflation and jobs. The third quarter has been a strong one for activity and rising energy prices will keep upward pressure on headline inflation. However, we feel that the combination of higher borrowing costs and less credit availability plus pandemic-era savings being exhausted and student loan repayments restarting should mean that households feel more of a financial squeeze in the fourth quarter and beyond. Higher gasoline prices, while pushing up inflation, will also erode spending power and likely weaken economic activity.
Rising credit card and auto loan delinquencies also hint at more pain with the Federal Reserve’s Beige Book warning that we may be in “the last stage of pent-up demand for leisure travel from the pandemic era”. Add in auto worker strikes and a potential government shutdown and we remain of the view that the economy will lose the strong momentum from the third quarter.
The concern is that economic softness could go too far (as highlighted by some officials in the July FOMC minutes) and heighten the chances of recession. Given this risk and the encouraging signs seen on core inflation and labour costs, we think the data flow gradually weaken the case for a November or December rate hike – which the market itself prices at only a 50% probability. Our base case continues to be more aggressive interest rate cuts through 2024 than the 50bp suggested by FOMC members today and 75-100bp priced by financial markets.
The 10yr still has upside
The Fed will be content that the market is sitting up and listening to its hawkish tilt. Even with unchanged rates today, the 10yr at 4.3% is suitably more restrictive than it was at the last FOMC meeting when it was below 4%. And it still has upside. The market discount for the bottom of the rate cycle has the funds rate at around 4%, and it has been drifting higher. That places fair value for the 10yr in the region of 4.5%.
The 2yr story is different. Today’s Fed update has seen the 2yr briefly nudge up to 5.15%. It probably does not need to be much higher. The bigger picture in the coming two years will be for the funds rate to be much lower than it is today. That does not need to break even versus a 2yr much above 5%. In fact, this is an area…
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