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FED A HAWKISH HOLD—OCTOBER/NOVEMBER FED MEETING LIKELY ANOTHER HOLD—BUT A CLOSE CALL—FED HIGHER FOR LONGER—RATE CUT UNLIKELY BEFORE SECOND QUARTER— HIGHER RATES, LONGER REFLECT ECONOMIC RESILIENCE

Date Posted: September 22, 2023

OCTOBER/NOVEMBER RATE DECISION WILL LIKELY DEPEND IMPORTANTLY ON THREE CPI AND FOUR PCE PRICE INDEX REPORTS PRECEEDING THAT MEETING—CLOSE CALL BUT EXPECT FUNDS RATE UNCHANGED IN NOVEMBER

In its September meeting, the Fed kept an unchanged but hawkish hold on its target range of 5.25-5.50%. Out of the nineteen members of the Open Market Committee, twelve looked for another increase this year while seven preferred no change. The Fed’s next meeting on October 31-November 1, will follow the release of three CPI and four PCE price index reports. During its November meeting, the Fed will likely assess the balance between concerns over inflation arising from the current strong economy and the uncertain delayed effects of the previous rapid increases in the funds rate. Balancing those concerns, the Fed will likely leave its target range unchanged—but that decision remains a close call. In either case, it will be approximately six weeks before the funds rate will likely reach its peak.

PEAK RATE LIKELY CONTINUES FOR SOME TIME INTO 2024—LONGER THAN FINANCIAL MARKETS EXPECT

Our past Commentaries often mentioned the Fed’s failed stop-and-go funds rate policies in the seventies and how they would likely influence current Fed policies. Given those concerns, members of the FOMC reduced their rate-cut projections for 2024 from four to two. Looking at recent history, the Fed usually waited 7-14 months after reaching its peak rate before making its first cut (see Figure 1.) If the peak rate occurred in July, then, a rate cut would likely occur in the second quarter of 2024. If, instead, the funds rate peaks in November, a rate cut would typically occur in mid-summer. However, presidential politics might force an earlier date. Finally, sounding like Chair Powell, incoming data will likely alter this outlook.

Figure 1
Federal Reserve, Upper limit of Policy Rates

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Sources: Federal Reserve Data, WOLFSTREET.com

SIGNS OF RATES IMPACTING ECONOMIC ACTIVITY

At its September meeting, the Fed nearly doubled its forecast for 2023 GDP to 2.1%. However, new signs indicate that the Fed’s higher rate policies might be affecting economic activity. More specifically, U.S. single-family house starts declined by over 4 percent in August. That suggests a significant impact from higher mortgage rates on new home sales (see Figure 2.) Admittedly that represents just one month and its worth noting that building permits increased by 2 percent. Furthermore, concerns arise from the fact that the Fed’s real rate policy only recently became restrictive which could potentially restrain economic activity (see Figure 3.) If these concerns prove more serious by the next Fed meeting, they may decide to leave the target range unchanged.

Figure 2
U.S. Housing Starts and Mortgages Rates

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Sources: LSEG Datastream—Reuters graphics

Figure 3

Fed Real Policy Rate Finally Restrictive

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Sources: BEA, Fed, Macrobond, ANZ Research, The Daily Shot

GOODS PRICE DECLINES MAY SLOW—RESULT GOODS INFLATION NOT SIGNIFICANT IN LOWERING OVERALL INFLATION RATE

The inflation outlook for goods and services will play a key role in the Fed’s next rate decision. Our previous Commentary (8/18/2023) highlighted how the reversal of supply-chain disruptions resulted in the rapid drop in goods inflation. With supply-chains now reopened and excess inventories moved out, goods inventory levels will likely begin to return to more normal levels (See Figure 4.) This gradual shift in goods pricing may no longer be a significant factor in lowering inflation. How soon that change impacts core inflation numbers will influence the Fed’s decision-making process.

Figure 4

Total Business Inventories to Sales Ratio (1/2021-7/2023)

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Sources: U.S. Census Bureau, fred.stlouisfed.org

SERVICES SECTOR INFLATION SHOULD DECLINE WITH LOWER SERVICE WAGES —KEY TO CONTROLLING PCE PRICE INDEX INFLATION

Services ex shelter contribute to roughly half of the core Personal Consumption Expenditures (PCE) Price Index. The PCE Price Index represents the key inflation measurement that the Fed monitors closely. Wage inflation will prove crucial to controlling inflation within many of the services sectors. According to the Atlanta Fed’s Wage Growth Tracker, wage inflation in services shows a decline from a peak of 6.6 percent in June 2022 to 5.4% in August (See figure 5.) In the last half of the prior decade, wage inflation typically ranged between 3-4 percent, a level that would help the Fed reach its 2 percent inflation goal. With the labor market gradually loosening up, the downward trend in service wage inflation should reduce inflation for the Fed. If this trend continues, it may reduce pressures for the Fed to raise the funds rate at its next meeting.

Figure 4

Wage Growth Tracker-Service Wages

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Sources: Current Population Survey, Bureau of Labor Statistics, Federal Reserve Bank of Atlanta

Investment Conclusions

Equities: The Fed’s recent decision, as well as the outlook provided in its Summary of Economic Projections acknowledge what Chair Powell called significant economic activity. Overall, the outlook for a soft-landing with moderating inflation remains unchanged. The Fed will likely leave its funds rate higher but this primarily reflects the overall strength of the economy. So long as the economy continues to show its resilience, equity markets should continue to provide attractive quality investment opportunities.

Fixed Income: As the Fed either reached or reaches its peak funds rate decision, moderately extending fixed income duration seems appealing due to the rise in long-term rates. Additionally, lower rated debt may also prove attractive if the economic outlook further improves. in such a scenario, incorporating alternative investments can also be used to diversify the portion traditionally committed to fixed income. Alternatives provide lower correlations with stocks and bonds, providing diversification benefits. Exploring alternative investments can help manage risk and potentially enhance returns in a changing market environment.