FOMC Review: Fewer 2024 Cuts More Likely Than Additional 2023 Hikes

Summary

• As expected, the Federal Reserve (Fed) hiked 25bp and Chair Jerome Powell pushed back against calendar guidance.
• Because Powell sees the current policy stance as already deeply restrictive and believes it has yet to fully filter through the economy, the Fed is more likely to respond to data surprises with fewer 2024 cuts than with additional 2023 hikes.
• A higher terminal Federal Funds Rate (FFR) would require a strong inflation shock, most plausibly an energy price shock that appears unlikely until late 2023.

Market Implications

• The market continues to underprice the Fed, especially in 2024.

No Surprise

As expected, the Fed hiked 25bp. All voters supported the measure even though Powell indicated during the presser that there was a wide range of opinion among meeting participants.

During the presser, Powell indicated that the data since the June FOMC meeting met expectations. The statement and the press conference opener upgraded the economic assessment from ‘modest growth’ in June to ‘moderate growth’ this time. The presser opener noted slower consumption, residential activity lower than a year ago, and weaker business investment.  

The labour market assessment was unchanged, ‘very tight’ but ‘supply and demand are coming into better balance.’

The inflation assessment was also unchanged; ‘it has moderated somewhat’ but ‘disinflation has a long way to go.’

Weaker Calendar Guidance

As I expected, Powell did offered no specific calendar guidance and instead repeated that, ‘We will continue to make our decisions meeting by meeting, based on the totality of incoming data.’ 

Unlike the June meeting when Powell said that, ‘It seemed to us to make obvious sense to moderate our rate hikes as we got closer to our destination’, this time Powell said, ‘We haven’t made any decisions about any future meetings including the pace at which we consider hiking.’ He added, ‘It’s possible that we would move atconsecutive meetings. We’re not taking that off the table. Or we might not. It really depends on what the data tells us.’

The change could reflect steady questioning of the rationale for a Fed June pause, not only at the June FOMC presser but also at the ECB Sintra conference in June. 

Powell Believes Restrictive Stance Has Yet to Fully Filter Through

The presser provided more guidance on the reaction function than I expected.

Like the FOMC doves, Powell believes the full impact of policy tightening has not filtered fully through the economy.

He believes the policy stance is deeply restrictive: ‘Take the Fed Fund Rate and subtract the near expectations and you get a real rate above most estimates of the longer-term neutral rate.’ 

Powell was likely referring to the 2yr BE as a forward-looking deflator for the FFR, which would translate into a real FFR of 3.3% compared with the SEP estimate of R* at 0.5% (Chart 1).

Powell also said, ‘It will take time for the full effects of our ongoing monetary restraint to be realized, especially on inflation.’

Fed More Likely to Cut 2024 Cuts Than Add to 2023 Hikes

Powell provided guidance on how the Fed would react to data surprises. First, he indicated that the key data the Fed was looking at were NFP, CPI, and ECI and growth indicators. 

Second, he stressed that a continued slowdown in wage growth was needed: ‘We don’t really think that wages were an important cause of inflation in the first year or so of the outbreak. But I would say that wages are probably an important issue going forward.’

Third, he indicated that, ‘At the margins, stronger growth could lead over time to higher inflation and that would require an appropriate response for monetary policy.’ This is consistent with the long-held Fed view that, ‘Reducing inflation is likely to require a period of below trend growth and some softening of labour market conditions.’

However, because Powell believes Fed policy is already in deep restrictive territory, positive surprises in GDP or wage growth would likely see the Fed cut its planned 100bp of 2024 cuts than raise its planned 2023 hikes. 

Powell hedged the rate hikes pencilled in the SEP: ‘Many people wrote down rate cuts for next year. But there’s a lot of uncertainty between what happens in the next meeting cycle let alone the next year, the year after that. So it’s hard to say exactly what happens there.’

For the Fed to add to its planned 2023 hike, BE or core inflation would have to increase significantly, which seems to me unlikely without a strong inflationary shock, most plausibly an energy price shock – most likely a late 2023 risk.

Fed Unconstrained by Banking Crisis, QT

Powell dismissed financial instability or quantitative tightening (QT) as constraining Fed policy. In his view, the banking crisis was over: ‘Things have settled down for sure out there. Deposit flows have stabilized. Capital and liquidity remain strong. Aggregate bank lending was stable quarter-over-quarter and up significantly year-over-year. Banking sector profits are coming in strong this quarter.’

He therefore no longer sees the banking crisis as an independent factor adding to the tightening of credit conditions typically associated with Fed policy tightening. Rather: ‘We’re just looking at the overall picture. Which is one of tightening credit conditions. And that’s going to restrain economic activity.’

While banking consolidation is continuing apace, there have been no signs of renewed stress. The Fed’s Bank Term Funding Facility has been flat since June, while DW lending has been falling (Chart 2). Simultaneously, bank loans are flat at small banks and have started to fall at large banks (Chart 3). Banks have attributed the contraction in their assets to the Fed’s forthcoming increase in capital requirements. This could be an additional reason for Powell’s wait and see stance.

Powell also asserted that the Fed could simultaneously cut the FFR and keep shrinking its balance sheet. This is because the FFR and balance sheet ‘are two independent things. The active tool of monetary policy is rates. But you can imagine circumstances in which it would be appropriate to have them working in what might be seen to be different ways but that wouldn’t be the case.’

This could be a new message relative to previous FOMC messaging, where balance sheet consolidation was viewed as contributing to policy tightening. Fed economists have computed that reducing the balance sheet by $2.5tn would be equivalent to a 50bp hike.

In any event, the combination of QT and rate cuts may not materialize if inflation proves as sticky as I expect.

Market Consequences

There was limited market reaction to the FOMC meeting. The market is still pricing a December 2023 FFR of 5.4%, below the SEP 5.6%, as well as a December 2024 FFR of 4.1%, below the SEP 4.6%.

I stick to my forecast of another hike in November. This is because I expect the data to print roughly in line with the current SEP 2023 forecast. In such an instance the Fed is likely to implement its slower hikes plan.

I also expect inflation to prove much stickier than either the Fed or the street expects, and for that reason I expect the Fed to start removing its planned 2024 cuts, starting with its 1 November 2023 meeting. It will happen after the first release of the Q3 GDP, which may well turn out more resilient than the Fed expects. 

Finally, an oil price shock could halt and even reverse the limited disinflation accomplished so far. In such an instance, the Fed would lift its terminal rate. An oil price shock, however, is most likely an end-2023 risk.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)