FOMC hold the line, pending further information
Risks around inflation and labour market resilience argue for another 25bps of insurance in July. But rate cuts will be required in 2024.
As anticipated, the FOMC left the fed funds rate unchanged at 5.125% in May. The accompanying statement was broadly the same as March, but the updated member forecasts showed greater confidence in the economy and uncertainty regarding inflation.
Built on the resilience of the labour market and growth’s persistence in early-2023, the FOMC median forecast for GDP growth has been revised up from 0.4%yr to 1.0%yr. The edging down of the growth forecasts for 2024 and 2025 to 1.1%yr and 1.8%yr only partly offsets the change to 2023. The net result for the labour market is a continuation of low unemployment, with a peak of 4.5% seen end-2025 and a ‘longer-run’ full employment level of 4.0%.
While the headline PCE inflation forecasts are essentially unchanged from March at 3.2%yr, 2.5%yr and 2.1%yr 2023 through 2025, the underlying strength of the economy has led core PCE inflation to be revised up 0.3ppts to 3.9%yr in 2023 and kept broadly unchanged at 2.6%yr and 2.2%yr for 2024 and 2025. That the end-2025 core PCE inflation forecast is above the 2.0%yr policy target is arguably as significant as the revision to 2023.
Consequently, FOMC members now project a year-end peak for the fed funds rate in 2023 of 5.6%, 50bps higher than March. The end-2024 and 2025 forecasts are also 30bps higher than the prior set, respectively 4.6% and 3.4%. Versus the ‘longer-run’ estimate of 2.5%, this implies Committee members believe it will prove necessary to keep policy restrictive for more than 2.5 years from today.
Against this central view, in the statement and press conference “the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation” as well as “[t]ighter credit conditions for households and businesses” were recognised as downside risks by the FOMC.
In our view, these uncertainties are likely to have a material impact on activity and, with a lag, inflation. So, while we believe the FOMC and market are justified in anticipating some further tightening near term – on balance, today’s decision leads us to believe one more 25bp hike in July is the most likely course – come early-2024 we expect the case to have been made for rate cuts.
For financial conditions today and over the forward estimates, the timing and scale of the impending rate cuts is the determining factor instead of the decision at July/ September. Through 2024 and into 2025, we see need for an aggressive sequence of rate cuts to bring both the short and long-end of the yield curve (the 10-year yield) back near 2.50% – the mid-point fed funds rate to 2.625%.
As telegraphed by Chair Powell in the press conference, a heightened degree of uncertainty clouds the outlook at present. It is therefore right to remain data dependent while awaiting a clearer understanding of how the balance of risks is evolving. Note though, whether inflation continues to surprise to the upside or growth disappoints, the US’ capacity is likely to remain constrained in the medium-term. The probability of recurring imbalance between growth and inflation is therefore material. While most apparent and most likely to sustain in housing, this dynamic is applicable across the economy.
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