US - Fed continues to steer tight financial conditions

Specifically, the statement said that ‘In determining the pace of future increases in the target range, 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.’ By linking the next policy decision to so many variables, the Fed is really leaving the market to guess what its next move might be. The hint that there would be a bias for a slower hiking pace came from the reference to the cumulative tightening so far and the lags with which monetary policy works. However, the dovish implications of this were offset by Powell’s statement that incoming data since the September meeting suggested rates may need to peak at a higher level, and stay at that level for longer than thought at the September meeting. This is consistent with the expectation we laid out in our preview. However, as we also stated then, we view this communication as a strategic move by the Fed to ensure financial conditions stay sufficiently tight for the time being, and it is unlikely that it reflects the Committee’s true current thinking over the path for rates.

Fed rate moves could be just as dramatic on the downside as on the up… – Although Powell reiterated that the Fed remains much more concerned about the risk of under-tightening than over-tightening, this came with a positive twist: he also stated that, if it appeared that the Fed had over-tightened, ‘we could use our tools strongly to support the economy’. Indeed, given our expectation for a significant rise (larger than the Fed’s expectation) in the unemployment rate over the coming year, we continue to expect significantly more rate cuts in H2 2023 than financial markets currently price in (-100bp vs market expectations of -33bp). Should a more negative scenario pan out, with a more rapid deterioration in the economy than we currently expect, this would likely lead to even bigger rate cuts – and potentially as rapid as the rise we have seen in rates so far.

…but we are not there yet – Still, we remain some distance from such a scenario at present. While demand has cooled significantly, the labour supply/demand imbalances remain huge, and inflation is still yet to meaningfully decline. For as long as this is the case, we expect the Fed’s signalling to markets to remain resolutely hawkish in order to maintain tight financial conditions. Our base case continues to be that the Fed hikes a further 50bp to 4.25-4.50%, most likely in one go in December, but we also see a risk that the Fed may seek to stagger this tightening over two meetings. However, this reduced hiking pace is likely to be accompanied by more hawkish rate hike projections in December, in order to offset the potential easing effect a reduced hike size would have on financial conditions. There is also still a significant risk that the Fed needs to go further than our base case expectation in raising rates, depending on how macro and financial conditions evolve. Even with the Fed pausing policy tightening early next year, we still do not expect a shift to more dovish communication that seeks to foster more accommodative financial conditions until Q2 2023.