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The US Federal Reserve (Fed) maintained its target interest rate at a range of 5.25% – 5.50% during its September 2023 policy meeting, as widely expected by most market participants. In the post-meeting press conference, Chair Jerome Powell communicated the Fed’s bias that additional policy firming may still be necessary to lower inflation to its 2% target.
In its updated Summary of Economic Projections (SEP) most Federal Open Market Committee (FOMC) participants projected an additional hike this year, while reducing their forecasts for the number of rate cuts in 2024. Market participants likely interpreted this as a bit hawkish relative to consensus, based on the sell-off in US Treasury yields across the curve, but particularly at the front end.
In my view, the Fed conveyed a high degree of confidence in a soft landing for the US economy based on its updated economic projections despite Powell suggesting during the press conference that it was not his base case. While tighter financial conditions are beginning to have their desired effect on lowering inflation, I still suspect it will exceed the Fed’s optimistic expectations into next year. US headline inflation, as measured by the Consumer Price Index (CPI), increased to 3.7% year over year in August 2023 — driven by surging energy prices — while the core inflation rate slowed to 4.3%. The Fed’s preferred measure, Personal Consumption Expenditures (PCE) price index core, ticked up to 4.2% year over year in July, and is projected to decline to 3.7% and 2.6% by the end of 2023 and 2024, respectively.
The Fed focuses on core inflation that strips out more volatile food and energy prices. However, the recent surge in oil prices (+35% since late June) may force another hike if these elevated levels prove durable and lead to more broad-based price pressures as businesses pass on costs to consumers or if they lead to inflation expectations beginning to move higher again.
I believe there is a high likelihood of another government shutdown beginning on October 1. It is important to distinguish government shutdowns (failure by Congress to reach an agreement on spending) from the debt ceiling (US statutory borrowing limit) fiascos. Each of these events has become commonplace due to increased polarization in Washington, but shutdowns generally do not result in lasting adverse impacts on growth, since wages/spending eventually “catch up.” However, because government employees are tasked with compiling economic data, there is a risk that key releases on inflation and employment will be unavailable to the Fed at its November and/or December meetings, depending on how long the shutdown persists. The United Auto Workers strike, which commenced on September 15, if protracted, could further cloud the Fed’s forecasts.
The market is currently pricing in roughly 50% odds of one more interest-rate hike this year, followed by cuts beginning in the second quarter of 2024. As of this writing, I believe the Fed has likely already reached its terminal policy rate and may prefer to begin rate cuts in in the first quarter of 2024 as economic data begins to roll over and before the presidential election cycle is in full swing. While I still expect that inflation will remain above the Fed’s 2% target by that time, prolonged higher inflation will have further translated into declining real wages for consumers at a time when their precautionary savings are likely to be depleted. Moreover, this will be occurring against a backdrop of rising unemployment and tight credit conditions. I therefore think the Fed should and will demonstrate a tolerance for above-target inflation since failing to do so risks tipping the economy into a more severe recession.
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The “cleanest dirty shirt” now has too many stains
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