The Federal Reserve Holds Rates Steady but Signals Prolonged High Rates

Recently, the policy committee of the Federal Reserve decided to keep the benchmark interest rate unchanged within the range of 5.25% to 5.5%. This decision did not come as a surprise. However, it had a significant impact on asset prices due to the fresh perspective the Fed offered on the future of monetary policy, economic growth, and inflation.

The Federal Open Market Committee (FOMC), which serves as the primary policy forum for the Fed, conducted a survey of its members, including all 19 individuals who either permanently or periodically contribute to the FOMC. Their forecasts have shifted in response to new information absorbed by the Fed. Notably, the Fed acknowledged the robust pace of economic expansion, with job gains remaining strong and unemployment staying low. Inflation, though, remains at elevated levels.

Despite expectations of tight credit conditions affecting economic activity, hiring, and inflation, the Fed acknowledges the uncertainty surrounding these effects. What remains certain, however, is that the economy continues to exhibit strength beyond initial expectations.

Furthermore, while the Fed decided to maintain the benchmark rate, predictions from FOMC members suggest the likelihood of one more rate hike this year. Additionally, these forecasts indicate a plan to keep rates elevated for an extended period. This implies that the Fed anticipates its current policy may further weaken labor markets, potentially suppressing wage inflation. Fed Chair Powell also mentioned that an easing of wage pressure could occur if there is an unexpected increase in labor supply, eliminating the need for monetary policy tightening.

The FOMC’s GDP forecast for 2023 has risen significantly from 1% in June to 2.1% now, and the 2024 prediction has increased from 1.1% to 1.5%. This demonstrates the committee’s growing optimism about economic growth over the past three months.

Regarding inflation, there have been slight shifts in the Fed’s predictions. The median forecast for PCE inflation in 2023 increased from 3.2% in June to 3.3%. However, the forecast for 2024 remained steady at 2.5%. When excluding volatile food and energy prices, core inflation for 2023 decreased from 3.9% in June to 3.7%, while the 2024 prediction remained at 2.6%. Despite expecting a stronger economy, the Fed appears confident that underlying inflation is on a favorable trajectory, necessitating no further tightening.

The question of when the Fed might cut rates arises. The FOMC’s median prediction for the Federal Funds rate in 2023 is 5.6%, indicating the possibility of one more rate hike. For 2024, the prediction increased from 4.6% in June to 5.1%, suggesting a potential delay in rate cuts, likely in late 2024.

The possibility of rate cuts, even if the economy remains strong, remains on the table, as long as real (inflation-adjusted) rates stay positive. This aligns with Chair Powell’s view that positive real rates help suppress inflation. Rate cuts can be considered while keeping real rates positive, as long as inflation remains sufficiently controlled.

If, however, inflation decelerates while the economy remains robust, the Fed may choose to keep rates unchanged. A scenario involving late 2024 rate cuts would likely result from declining inflation and a significant economic slowdown.

Following the FOMC’s recent predictions, short-term bond yields and the value of the US dollar surged. These shifts reflect expectations of a stronger economy, prolonged high interest rates, and gradual declines in inflation.

Worrisome Outlook for Fourth Quarter US GDP Growth

Anticipated third-quarter US GDP data, set for release on October 26, is expected to reveal robust growth. The initial two months of the third quarter have shown strong economic indicators. However, concerns are growing regarding the outlook for the fourth quarter due to several factors.

These concerns include the ongoing impact of past monetary policy tightening over the past year, the resumption of student debt servicing in October affecting millions of borrowers, the possibility of a government shutdown, and the potential for an extended strike by automotive workers that could disrupt supply chains, leading to temporary job layoffs.

One of the most significant factors that could impede economic growth is the rebound in oil and gas prices. In August, a surge in gasoline prices already dampened spending on non-gasoline goods. Further price increases could suppress real consumer spending and potentially trigger inflation, prompting the Federal Reserve to tighten monetary policy more than anticipated.

There is also debate surrounding the impact of the return of student debt payments. Debt service payments on Federally funded student debt were halted during the pandemic but are set to resume on October 1. The resumption will reduce discretionary income by approximately $100 billion for debtors, though this is a small fraction of the $18 trillion in annual consumer spending.

The actual impact on the economy depends on debtors making full and timely payments, and it may be offset by lower- to middle-income debtors participating in programs like Saving on a Valuable Education (SAVE) that offer reduced monthly payments based on income. Strong job growth and rising real wages are expected to mitigate the effect of new student debt payments.

British Inflation Eases, Bank of England Takes a Pause

Inflation in the United Kingdom has declined, but core inflation remains persistent and elevated. This decrease in inflation compared to previous expectations is influencing investor outlook on the Bank of England’s (BOE) future actions.

Consumer prices in the UK rose by 6.7% in August compared to the previous year, down from 6.8% in July, marking the lowest annual inflation rate since February 2022. Recall that inflation had peaked at 11.1% in October 2022. Core prices, which exclude volatile food and energy prices, were up by 6.1% from the previous year in August, down from 6.9% in July, but they have remained relatively stable since early 2022.

The decrease in inflation, particularly core inflation, has led investors to reconsider their expectations for BOE policy. Initially, bond yields and the pound fell in value as it was expected that the BOE would not tighten monetary policy as aggressively as previously thought.

Two days after the release of inflation data, the BOE decided to keep its benchmark interest rate unchanged at 5.25%. The policy committee’s vote was closely divided at five to four, with BOE Governor Andrew Bailey casting the decisive vote to maintain steady rates. This decision comes after two years of rising rates, leaving some observers wondering if it signals the end of monetary tightening.

Additionally, the BOE’s decision follows a similar one by the US Federal Reserve, which is expected to raise rates again before the end of the year. Nevertheless, many observers now anticipate that the BOE will keep rates unchanged. While the BOE policy committee suggested that the current monetary policy stance be “maintained” until further progress is made on inflation, the swaps market still prices in a 70% probability of another rate hike this year, down from 80% before the inflation data release.

In response to the BOE’s inaction, the pound depreciated further, having already experienced a decline following the release of inflation data. The pound has been falling since mid-July when it reached $1.31 per pound, and it is currently slightly above $1.22. This decline reflects expectations that the interest-rate gap between the United States and the United Kingdom will likely widen or, at the very least, not narrow. It also reflects the anticipation that the US economy will outpace the UK economy in the near term.

Japanese Inflation Persists, Bank of Japan Maintains Status Quo

In Japan, core consumer prices, which exclude fresh food but include energy costs, rose by 3.1% in August compared to the previous year. This rate has remained consistent in four of the past seven months. When energy costs are excluded, core-core prices increased by 4.3% from the previous year, mirroring trends in three of the last four months. This suggests that underlying inflation in Japan has stabilized at a level significantly higher than pre-pandemic levels but below late 2022 levels, indicating a persistent inflation challenge.

Japanese inflation, unlike in the United States, is mainly attributed to goods, with goods prices rising by 4.2% in August, while services prices increased by a more moderate 2%. Wages are also rising more slowly than prices, resulting in a 16-month decline in real earnings for households.

The Bank of Japan (BOJ) has maintained that the inflation is driven by supply-side factors rather than demand-side forces, arguing that monetary policy tightening is unnecessary due to the abatement of the supply-related factors driving inflation. However, despite supply factors subsiding, inflation has persisted, suggesting that it has become ingrained in market participants’ expectations. Historically, tightening monetary policy has been an effective means to challenge these expectations, but BOJ Governor Ueda recently stated that the low-interest-rate policy will remain in place.

As a result, the value of the yen has decreased, reflecting diminished confidence in the BOJ’s intention to tighten monetary policy anytime soon. In August, the real effective value of the yen, which measures its purchasing power against a basket of other currencies, reached its lowest level since 1970. This has increased the relative cost of imports to Japan, impacting the purchasing power of Japanese citizens. Furthermore, currency depreciation can contribute to inflation. On the flip side, a weaker yen can boost the competitiveness of Japanese exports.

In September, the latest Purchasing Managers’ Indices (PMIs) for Japan were relatively positive, although they indicated a slowing pace of economic growth. The services PMI decreased slightly to 53.3, while the manufacturing PMI remained relatively stable at 48.6. The composite PMI declined from 52.6 in August to 51.8 in September, suggesting modest economic growth. S&P Global noted that the rate of growth was only modest and the slowest recorded since February, with forward-looking indicators suggesting the potential for softening demand and activity in the coming months. This may explain the BOJ’s reluctance to tighten monetary policy.