Fed nears the peak in rates

Tightening bias softened, but retained

As we had expected, the policy statement and Chair Powell’s remarks in the press conference acknowledged the risks to the economy from the recent turmoil in the banking sector, but also still left the door open to further rate hikes. The bias for further tightening was softened from previous statements, with the expectation of ‘ongoing rises’ in rates replaced with the statement that ‘some additional policy firming may be appropriate’. In the press conference, Powell clarified that much would depend on the degree to which recent stress in the banking sector and financial markets impacts lending to the real economy. Here, Powell remarked that the residual tightness was ‘probably more than traditional financial conditions indicators suggest’, and that it would take time for the ultimate impact to become clear. This therefore creates uncertainty over the path of interest rates going forward, with rates potentially having to rise further if the current tightness in financial conditions unwinds more rapidly. At least according to the traditional indices, conditions have eased significantly over the past few days, with more than half of the tightening in the Bloomberg financial conditions index since the turmoil broke out having already unwound, and the index now at around the same level as in December.

FOMC projections broadly unchanged; rate cuts not seen until 2024

Despite the dovish shift in the policy statement, the Committee’s quarterly update to its projections showed that its outlook was broadly unchanged. Expectations for GDP growth were revised marginally lower, and inflation marginally higher. On rates, the Committee median stayed at 5.1% for the fed funds rate in 2023, implying one further rate hike, while the expectation for rate cuts in 2024 was pared back modestly, with the fed funds rate now projected at 4.3% compared with 4.1% previously – i.e. implying roughly 75bp in rate cuts next year. When questioned in the press conference, Powell confirmed that most Committee members had incorporated into their projections some expectation that recent banking stress would bear down on credit growth, and that in the absence of this members would have been minded to raise their expectation for the peak in rates, given the continued strength in the labour market and inflation (indeed, Powell himself indicated this in his testimony to Congress just before the recent turbulence broke out). This suggests that, should financial conditions continue to ease, the Committee is likely to want to raise rates further.

We expect one further hike, with cuts now to start in December

Given the recent bad news on inflation, and with financial conditions continuing to ease significantly in recent days, we now expect one further 25bp hike by the Fed, taking the fed funds rate to 5.00-5.25%. We have also pushed back our expectation for rate cuts, which we now expect to start in December rather than September, and this is due to the greater resilience in the labour market than we expected at this point in the cycle. Once rate cuts start, our base case is that they continue at a 25bp pace at each meeting until policy returns to neutral levels; i.e. we expect the fed funds rate to be at 2.75-3.00% by end 2024, and to be back at neutral (c.2.5%) in early 2025. As the Fed has itself communicated, there is significant uncertainty around this forecast, and much will depend on how financial conditions evolve and are transmitted through the economy.