FOMC keeps rates on hold, meeting market expectations

The Fed last night delivered what was widely expected by the markets: interest rates kept on hold but with the threat of further rises left on the table should they be warranted, ie a hawkish pause. Indeed, 12 of the 19 Fed officials still expect to raise rates at least once more this year. Alongside this was the message that borrowing costs will remain higher for longer as the economy continues to prove more resilient than expected to the Fed’s policy actions, with fewer rate cuts now seen in 2024 than previously anticipated. In large part this reflects the strength that has been seen in the labour market. The Fed Funds rate is now forecast to be at 5.1% by end-2024 according to their median estimate, up from the 4.6% projected in the last dot plot released in June.

Beyond that, the statement itself was little changed to the last meeting, the key difference probably being the reference to the labour market which is now described as having “slowed” instead of being “robust”. This is an acknowledgment that one of the key parameters necessary for the FOMC to see before it will consider loosening policy again, ie a weakening labour market and slower wages growth, is finally starting to materialise, albeit slowly. However, that strength bodes well for the FOMC to deliver the soft landing it has been hoping for, ie cooling inflation without driving the economy into recession.

But as with its peers, the main determinant of interest rate policy will be how the inflation picture evolves going forward and Powell very much acknowledged this by saying that policy decisions will now be much more data dependent. In this respect the Fed’s forecasts for CPI look quite aggressive. The forecast for core PCE this year has been lowered marginally from 3.9% to 3.7% but has been left unchanged for next year at 2.6%, with inflation not now expected to return to its 2% target until 2026. This is probably over cautious and our own expectations are for inflationary pressures to recede a little faster than the Fed is expecting. Understandably the Fed is not willing to take any risks in declaring too early that the battle with inflation has been won. Having got the ‘transitory’ inflation argument so wrong it will be making sure that inflationary pressures have been fully squeezed out of the economy before making this declaration and materially easing the monetary stance. Reputations for central banks matter, and the Fed – just like its peers the BoE and ECB – is in the process of rebuilding its credibility with the markets. The potential cost of this caution is lower growth and higher unemployment.

The forecast for GDP is now expected to come in at 2.1%, a considerable upwards revision from the 1.0% forecast in June and predicated almost entirely on the strength of activity seen over Q2 and Q3. How long this strength will last for is the big uncertainty. From the language the Fed used, it clearly expects to see much of this strength maintained going forward, hence the need for a more restrictive monetary stance. This stronger growth outlook is reflected in the forecast for the rate of unemployment, which is now seen ending the year at 3.8% as opposed to the previous forecast of 4.1%. For the Fed, a lower rate of unemployment means faster wages growth and a higher risk of inflation and is likely the key reason behind the slower pace of interest rate reductions forecast for next year. Our own expectations are that this strength will not last as long as the Fed is expecting and that growth – and inflationary pressures – will dissipate more rapidly. Domestic consumption is showing signs of slowing and the strength of consumer behaviour seen over H1 looks unlikely to carry on into H2 and 2024.

On balance, therefore, it is a relatively optimistic outlook being presented by the Fed, with growth and employment largely holding up – albeit slowing moderately – and interest rates starting to ease back next year, but again more slowly than previously expected. But the key take-away is probably that the Fed still believes the ‘soft landing’ it has been seeking is achievable. But as ever, time will tell.