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The US Federal Reserve (Fed) kept its target interest rate at a range of 5.00% – 5.25% at its June 2023 policy meeting, a decision most market participants had expected. In the post-meeting press conference, Chair Jerome Powell reiterated the Fed’s stance to maintain a data-dependent approach over its next few meetings.
While some Fed officials have recently expressed unease about persistent inflation pressures, I believe several factors should contribute to economic growth slowing enough to enable inflation to moderate further as the US labor market weakens.
While the level of inflation will probably settle above the Fed’s 2% target, the corresponding increase in the unemployment rate will likely provide cover for the Fed to keep rates on hold for the foreseeable future. The Fed is characterizing the lack of policy-rate action at the June meeting as merely “skipping” a hike, but I believe the Fed will find itself on an extended pause.
I see several downside risks to US growth over the balance of this year. The recent, well-documented banking sector stress appears to have abated for now, but smaller businesses that rely more on bank credit lines remain vulnerable, in my view. The allure of higher money market rates will continue to attract deposits away from banks, which could result in further balance-sheet reduction and make it more difficult to raise much-needed capital. The implication for the economy is tighter bank lending standards that could choke growth.
While the debt ceiling resolution removes a significant tail risk from the market, it will still have lasting effects. Rebuilding the depleted Treasury General Account (which the Treasury was forced to draw down due to the debt ceiling) will remove reserves from the banking system, a headwind to financial conditions.
Furthermore, the deal between lawmakers to raise the debt ceiling included provisions such as spending caps on certain discretionary spending and a clawback of unused COVID-19 funds that will result in a net negative GDP impulse of around 0.40%, based on calculations by my colleague and Macro Strategist Mike Medeiros.
Milton Friedman famously quipped that monetary policy works with a “long and variable” lag. The Fed’s tightening campaign has been aggressive and may be long in the tooth, but I believe rates have only been in restrictive territory since late 2022, indicating their full effects have yet to be felt. This is likely to change soon.
The US headline inflation rate, as measured by the Consumer Price Index, eased further, to 4.0% year over year in May 2023, while the core inflation rate slowed to 5.3%. These were the lowest readings since March 2021 and November 2021, respectively. This represents good progress and most of the leading indicators I track suggest that core inflation will decline toward 3% by the end of this year.
This said, wage pressure remains acute amid continued labor market strength — job creation in the payrolls reports and elevated job openings both suggest sustained pressure on wages. As we look forward, I expect to see the US labor market soften, which should result in wages continuing to moderate as both labor supply and demand move more into balance.
The market is currently pricing in better than 50% odds of one more interest-rate hike at the July Federal Open Market Committee (FOMC) meeting, followed by cuts beginning in the fourth quarter of this year. As of this writing, I believe the Fed has already reached its terminal policy rate and is now likely to keep rates “on hold” for the foreseeable future so as to assess whether monetary policy is restrictive enough to keep lowering inflation without tipping the US economy into recession. My bias is that the evolution of inflation and labor market data will provide scant ammunition for Fed watchers (and hawkish FOMC members) who believe further tightening is necessary.
If my forecast proves prescient, I expect high-grade fixed income portfolios could benefit from a long-duration bias. Interest-rate volatility will likely decline as the probability of rate hikes (and quantitative tightening) declines, supporting agency mortgage-backed securities. I’m still cautious on credit because I don’t think markets have fully engaged on the possibility of further economic slowdown. In the near term, I believe a Fed pause and the strength of the US consumer are supportive of risk assets. I’m favorable on high-quality, short-duration consumer asset-backed securities and see a case for considering select investment-grade corporate credit exposure.
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The real issue on rate cuts? Keep your eyes on the dot (plot)
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