September 22, 2023 | 17:02
Fed Policy Rates: Whether a Hallowmas Hike It’s Higher for Longer
The FOMC kept the fed funds target range unchanged at 5.25%-to-5.50% on September 20, as was widely expected, after lifting it by 25 bps last meeting. This repeats the first part of the skip-hike sequence established three months ago. And, the Fed left the door open for a potential second-leg rate hike come next announcement on November 1. But it’s uncertain whether the Committee will ultimately cross the sill.
Firstly, the policy statement recited the forward guidance of the prior two meetings. It said: “In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” The “may be appropriate” phrase affords the Fed a lot of flexibility. This guidance foretold both July’s hike and September’s skip and, therefore, can accommodate either policy choice.
Secondly, in the Summary of Economic Projections (SEP), the median forecast for the fed funds target range at the end of this year remained at 5.50%-to-5.75%, implying a potential 25 bp increase on November 1 or December 13. However, despite the unchanged median projection, the Fed’s rate hike conviction appeared to abate a bit. There are now seven participants forecasting a below-5.625% midpoint peak, compared to six before. This means one participant backed off their prior projection. And there are no above-5.625% forecasts this time, after three before. These changes are reflected in the slight reduction in the mean projection for 2023-end (by 3.7 bps).
Thirdly, in the press conference, Chair Powell reiterated that the SEP is not a “decision or plan” and stated that the policy decision made over the last two meetings of the year will depend on the “totality of the incoming data”. In other words, the jury is waiting for further evidence. Between now and November 1, we’ll be focussing on the key reports in the attached table, and we suspect the Fed’s hit list isn’t much different. (Of course, this presumes a government shutdown doesn't postpone any releases.)
Whether the results will be strong or hot enough to convince the Fed to hike rates, we’ll just have to wait and see. Currently, our base case is for no more rate hikes this year (like those seven FOMC participants) but it’s a very close call. For the record, the market is pricing the odds of a November move at 29% with December at 54% and January at 57%.
Another critical development amid this week’s policy pronouncements was the Fed’s emerging recognition that policy rates may have to remain higher for longer than previously anticipated. Again, in the SEP, the median forecast for the fed funds target range now shows 50 bps of easing by 2024-end to a 5.125% midpoint, down from 100 bps before. Moreover, 10 of 19 participants have an above-5% year-end call compared to six before. With 2026 projections introduced, the 2025 forecasts were probably sharpened. And, there’s still 125 bps of easing during that year, but of course ending 50 bps higher at a 3.875% midpoint. The inaugural 2026 median has a further 100 bps of easing to 2.875% by year-end.
It’s noteworthy that the policy rate is projected to remain above its longer-run level for yet another year (the level is 2.5% according to the median call or 0.5% in real terms). In the presser, Chair Powell said that “it’s certainly plausible that the neutral rate is higher than the longer-run rate”, which is also “part of the explanation for why the economy has been more resilient than expected”. And the unstated corollary would be that it’s also part of the explanation for stubborn underlying inflation. To address the resiliency and stubbornness, the Fed must push policy rates even further above this higher shorter-term neutral rate, particularly in real terms.
With the median forecast for core PCE inflation in 2023 lowered a couple of ticks to 3.7% y/y (Q4/Q4), partly owing to a subdued June-July starting point, real rates are projected to top 1.9% by year-end. Next year’s 1.1 ppt drop in projected inflation (to 2.6%) is more than the ½ ppt drop in nominal policy rates, resulting in even higher real rates, to above 2.5%. To put this in context, such real policy rates haven’t been this high since just before the Great Recession, which underscore both the high intensity of resiliency/stubbornness pressures and the net risk of much weaker economic outcomes next year.
Afterwards, the median profile has nominal rates falling faster than inflation, reducing real rates to near 0.9% by end-2026. Again, it's noteworthy that despite real GDP growth, the unemployment rate and total/core PCE inflation all returning to their longer-run levels by end-2026 (1.8%, 4.0% and 2.0%, respectively), policy rates remain above their longer-run level (at 2.875% vs. 2.50%). This implies that the FOMC’s median forecast for the (longer-run) neutral rate could be poised for change; it’s been stuck at 2.50% since June 2019. Indeed, five participants now judge that it’s above 2.75% compared to three in the prior SEP.
Meantime, we’re not waiting for the Fed. Our current estimate of the longer-run neutral rate (2.625%) is already a bit above the Fed’s. Given the resilient growth (we recently pulled our mild recession call) and inflation risks running through our own projection, we’re lifting our neutral number to 2.875%, the midpoint of the 2.75%-to-3.00% range. (Note that in an abundant reserves monetary policy framework, a shift back to fed funds point-targeting from range-targeting is unlikely anytime soon.) And we’re not alone in thinking the root of the yield curve could be ‘higher for longer’. This week, 10-year Treasury yields also hit their highest level since just before the Great Recession (October 2007), nearing 4.50%. Next week, we'll hear from Chair Powell again. We anticipate a similar messaging to the presser, one that the bond market is now hearing loud and clear.