Fed Note: September 20, 2023
The Federal Reserve Open Market Committee kept the Fed funds rate unchanged today at the current level of 5.25-5.50%. The vote was unanimous. The formal statement was minimally changed, other than economic activity being upgraded from a ‘moderate’ to now a ‘solid’ pace. At the same time, the reference to job gains was downgraded from ‘robust’ to ‘slowed...but remain strong.’ The reference to the U.S. banking system was kept in the statement, interestingly, with the continued warning about tighter credit conditions potentially weighing on activity going forward. The quarterly Fed’s Summary of Economic Projections (SEP)  showed the path of the Fed funds unchanged for 2023 (at 5.6%, which implies another hike), compared to the June report, and higher for 2024 (4.6% to 5.1%), and 2025 (3.4% to 3.9%), although the longer-run 2.5% level remained intact. Today’s inaction was expected by markets. Based on Fed funds futures , the odds of staying put had been steadily rising from 80% to 99% over the past month. In looking at the remainder of 2023, futures indicate odds of about 40% for one more rate hike, which is assumed to be the high point of the cycle. The most important change has been an evolution to far less dramatic expectations for rate cuts in 2024. Markets still assume some cutting will take place, but rather than finishing as low as a 3.5%-ish level a few months back, the Dec. 2024 highest probability now hovers around 4.5%. This still reflects the Fed normalizing rates lower over the next year from what are deemed today’s ‘restrictive’ levels, but also assumes a more gradual pace and a ‘soft landing’ that pre-empts the need for strong cuts as seen in recession. Of course, futures market assumptions can change quickly with conditions. Economy. The Fed’s SEP showed U.S. GDP growth for 2023, 2024, and 2025 at 2.1%, 1.5%, and 1.8%, respectively, reflecting an upgrade for this year and next, relative to June. Economic growth continues to move in a positive direction, with expectations for Q3 staying well above long-term trend levels, and even that of recent quarters. The closely-watched Atlanta Fed’s GDP Now  measure, which uses data released so far, points to a growth rate of 4.9%. This is still assumed to be a bit on the high side, but even the Blue Chip economist consensus estimate has risen from around 0% in June, steadily upward to now around 3%. Interestingly, some commentators have noted the surprisingly strong impacts of consumer spending around Amazon Prime Day, as well as even Taylor Swift and Beyoncé concert tours (large crowds indulging in expensive tickets, travel, hotels, restaurants, etc.). The latter again demonstrates the strong and resilient recovery in the services part of the economy. As seen in the two key ISM measures, services continue to expand, while goods manufacturing is still contracting (although improved upward from trough levels). This remains a conundrum. As classic leading indicators and recession ‘checklists’ almost universally still point to recession, recent monthly releases have been flat to benign. As Q3 comes to an end and we enter Q4, pressures remain, not the least of which include the lagged impact of rising interest rates over the past year (including the doubling of mortgage rates, pulling down home affordability), ongoing depletion of consumer savings, autoworker strike, moratorium on student loan payments ending, and a potential government shutdown. (For the latter, it’s important to note that, historically, the nearly two-dozen shutdowns have been relatively brief and not all that meaningfully negative to economic growth. However, from a practical standpoint, it could also mean no government economic data is produced during a shutdown, making evaluation more challenging, potentially adding to market uncertainty.) One interpretation of today’s environment is that a recession may just be delayed, as opposed to avoided altogether, but higher interest rates continue to apply a tightening effect. The addition of all these risk factors raises the odds of a ‘sudden’ mishap where the economy seems ‘fine until it isn’t.’ This may just be an academic argument, since a recession ‘has’ to occur at some point, but it doesn’t mean one needs to be severe. While many investors are sensitized to the slowdowns of 2008 and 2020, typical recessions are not nearly as dramatic, with underlying conditions arguably a lot healthier this time. Inflation. August CPI  came in showing a trailing 12-mo. rise of 3.7% for headline prices (a half-percent higher pace versus July due to higher oil prices) and 4.3% for core, ex-food and energy, which was an improvement lower from July. The Fed’s SEP for 2023, 2024, and 2025 shows PCE inflation expectations at 3.3%, 2.5%, and 2.2%. Goods inflation has fallen sharply, seen in the results of ‘all items less shelter’ up only 1.9% over the past year. This again points to housing and rents as very sticky and lagged inflation inputs. Higher energy costs have also played a role in recent months to push headline inflation higher, with indirect by meaningful carry through to other sectors. That said, the path to more ‘normal’ inflation has been frustrating with fits and starts, but charts show continued improvement. The final stretch in getting from 4% to 2% CPI has required a lot more patience than the initial improvement from 9% to 4%, which the Fed acknowledges. Employment. The Fed’s SEP showed unemployment rate expectations for 2023, 2024, and 2025 at 3.8% (down by -0.3% from June), 4.1%, and 4.1%, respectively. Labor markets remain strong, although there has been some weakening from peak levels. This also points to a softer landing scenario, with job opening-to-worker ratios falling, but that tends to be far less significant than a spike in layoffs, which impact real workers. The unemployment rate has also risen, but also seems to reflect more workers coming back into the labor force. This could be due to pandemic savings starting to run out, which has also been echoed by rising credit card balances and a tick up in delinquencies. As one of their two mandates to manage to, the Fed watches labor stress closely as an indicator of how ‘restrictive’ its efforts have been. Thus far, the resilience in job markets has continued to give the Fed a green light to keep hiking, but labor markets have tended to be a lagging indicator, so the official stats may not match up precisely with current conditions. That said, current conditions do not appear to be onerous for labor, with wage growth and worker strikes an example of higher employee bargaining power relative to employers. Financial markets remain intently focused on when the Fed will finish the rate hiking process. It may not be that simple, with the potential for another hike or two based on upcoming data. An unknown variable (at least in advance) is where the neutral rate lies—the point where monetary policy is neither tight nor loose. Upcoming rate policy is hinged on the balance of inflation improvement, with noise recently from higher oil prices, and duration of positive economic growth. These aren’t mutually exclusive paths. Perhaps not fully accounted for are the ‘long and variable lags’ of higher interest rates, with the cumulative effects of tightening increasingly taking their toll on the economy. That is also the point. No policymaker or economist tends to ever outright say ‘I want a recession’—even though a recession has often been required to bring inflation down historically. Then again, once the Fed reaches a peak in policy, and turns from a tightening to easing bias, history has shown that to be at least a modestly favorable starting point for stock and bond returns, depending on other conditions at the time. Sources:  Federal Reserve (https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm)  CME Group (https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html)  Federal Reserve Bank of Atlanta (https://www.atlantafed.org/cqer/research/gdpnow.aspx)  U.S. Bureau of Labor Statistics (https://www.bls.gov/cpi/, https://www.bls.gov/ppi/)
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Sources: Ryan M. Long, CFA; Director of Investments; FocusPoint Solutions, Inc.
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