Another Fed meeting, another installment of What Will the Fed Do Next?

Earlier this month, the Federal Reserve (Fed) voted unanimously to hold the benchmark rate in the current 5.00%–5.25% target range. This move, or lack thereof, was largely expected, as inflationary and employment data leading up to the decision signaled continuity in progress toward lower inflation. The first pause since the onset of the tightening cycle in early 2022 was to “assess additional information and its implications for monetary policy.” The Fed went on to signal an eventual continuation of the hiking cycle by referring to its desire to determine the “extent of additional policy firming that may be appropriate.” While we may have expected the pause, or as Fed Chair Jerome Powell accidentally called it, the “skip,” to be the big news of the day, it was really the clear warning that the Fed still expects rates to continue higher.

As the Fed does quarterly, it released the updated Summary of Economic Projections (SEP). A few interesting revisions signaled both a rise in expected economic growth and inflation along with a decline in the expected unemployment rate:

  • 2023 and 2024 federal funds rate: The median projection for the 2023 year-end federal funds rate rose to 5.6% from 5.1%, signaling that the Fed expects to hike twice more before this year concludes. As has been the norm throughout the latter half of this tightening cycle, the market disagrees with the Fed’s projection. As of June 23, 2023, interest rate futures imply a 5.26% rate in December. The 2024 year-end rate projection also rose to 4.6% from 4.3%, further supporting the Fed’s unofficial slogan of “higher for longer.”
  • Change in real GDP: The median projection for the year-end change in real gross domestic product (GDP) increased to 1.0% from the 0.4% the Fed members projected back in March, reflecting what has been an incredibly resilient economy in the face of a historically fast-paced tightening cycle.
  • Unemployment rate: The median projection for year-end unemployment was cut to 4.1% from 4.5%. Earlier in the month, the unemployment rate for May came in at 3.7%. While slightly above the 3.4% rate we saw in April, the current unemployment rate is still firmly below both its historical average as well as the Fed’s year-end expectation. In aggressive recessions, we often see drastic spikes in unemployment, rather than small rises of 30 basis points (bps) from month to month. For example, between the end of 2008 and 2009, unemployment rose 390 bps from an already elevated 6.1%, with the bulk of that coming in just the first quarter of the year.
  • PCE inflation: The median projection for Personal Consumption Expenditures (PCE) inflation was cut slightly to 3.2% from 3.3%, while PCE core inflation rose to 3.9% from 3.6%. Also worth noting is the longer-run PCE inflation target, which remained at 2%. It has been discussed by both investors and members of the Fed if this target should be raised given how high inflation is, but the Fed ultimately stuck to its long-standing 2% inflation goal.

While most investors focus on the median projections in the SEP, the Fed also provides us with central tendencies and ranges, which can often be insightful. While the ranges include all projections, central tendencies exclude the three highest and three lowest projections for each measure. The low end of the central tendency range for the 2023 federal funds rate rose to 5.4% from 5.1%, showing further solidarity among Fed members that there will be at least one more rate hike. Of the 18 Federal Open Market Committee participants, nine have penciled in two more hikes, and three have written down even more hikes than that. The low end of the central tendency range for the 2024 federal funds rate also rose to 4.4% from 3.9%, supporting the narrative of interest rates being higher for longer.

Hold Please . . .

There are several impetuses that could keep this tightening cycle on pause. The markets would ideally like to see inflation dropping faster than what the Fed’s SEP suggests. As we have noted in the past, core services excluding housing is the most sticky and stubborn component of inflation. Chair Powell called this metric out once again saying, “We see only the earliest signs of disinflation [in services].” Powell rightly noted that the largest cost driving core services inflation is wages, which explains why many investors would say the key to getting services inflation down is a continuation of the loosening in labor market conditions.

Housing costs are historically more predictable given the inherent lag between market conditions and the Consumer Price Index (CPI) releases. Powell specifically called out a lack of progress on bringing down rental costs saying, “You’re just not seeing a lot of progress, not the kind of progress we want to see.” He went on to explain that new rents are coming in at low levels, and in time, that should pull down housing inflation. Annual rent inflation stood at 8.7% in May, with shelter costs up 8% year over year. Housing costs accounted for more than 60% of the total increase in core CPI in May. Given that rental costs are roughly one-third of CPI and one-sixth of the PCE, a drop in primary residence and owners’ equivalent rent could bring headline CPI down dramatically.

The final major component, goods inflation, has been slowed not only in part by the shift of demand from goods to services but also by a continued improvement in supply conditions. May producer prices (PPI) have hinted that continued price deflation may be imminent, with headline PPI down 0.3% on a month-over-month basis and up only 1.1% on a year-over-year basis, down significantly from the 2.3% in April.

Three other main factors could induce a continued halt to the tightening cycle, but they are a bit drearier: reduced economic activity, dramatic market volatility and a spike in unemployment. An economic recession generally comes within two years after the end of a tightening cycle and is often the catalyst for a series of rate cuts. We would hope that the Fed can heed warning signs of an impending recession before it hits. Market volatility can often come right before the conclusion of a tightening cycle. For example, the “Powell pivot” in January 2019 came just one month after the 10% slide in the S&P 500 Index. A spike in unemployment, as we said previously, is often what happens after the conclusion of a tightening cycle as employers prepare themselves for a slower economy. Employment is one of the most lagging indicators of the business cycle, which makes it hard to point to as a signal of anything. Other job market metrics attempt to circumvent that lag but can also be faulty. The Job Openings and Labor Turnover Survey, while helpful, has had a low response rate. Job listings, like those provided by employment website Indeed, provide great insight, but they can be difficult to rely on given the ambiguity around the mix of part-time versus full-time listings. Jobless claims and major employer headlines will likely be in the spotlight going forward as they have the least inherent lag among available labor market indicators.

4th Escape or 12th Recession?

Again, the market is betting that the Fed hikes less than what the SEP would imply. So, market participants think one of the catalysts we mentioned previously could happen. Who can blame them? Eleven out of 14 tightening cycles since World War II have been followed by a recession within the following two years. When inflation is north of 5%, every single tightening cycle has been followed by a technical recession within those two years. But there’s a first for everything. The Fed’s monetary tools are blunt force and it’s hard to predict the ultimate effects they will have, but we have an ever more connected and informed world of data that the Fed, employers and investors alike can draw from. We cannot yet count out a soft landing. The economy and job market are resilient, and disinflation has been gradual. Even if this does become the 12th recession, we expect it to be mild at worst.

What Has Changed?

There will be an even larger emphasis on the monthly data releases. Employment and inflation are top of mind for investors so CPI, PCE, jobless claims and wage inflation data will all likely move the needle if they surprise the market. Barring any major shocks, it is likely the Fed hikes another 25 bps by September. The June CPI report will have an interesting roll-off of the June 2022 hot number, which should bring headline inflation down nicely. Again, the market expects something to keep the Fed from completing the remaining 25 bps of cumulative tightening. We will continue to digest the data and brace ourselves as Captain Powell brings the hawks, doves (and pigeons) in for landing.

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