The story so far
It may be a distant memory, but as late as March 2022, the Federal Funds Effective Rate was still at zero. 11 hikes later, it is now it is at a 23-year high, and the war on inflation is still very much ongoing despite the early progress made in 2022.
Source: St. Louis Federal Reserve, Atlanta Federal Reserve
Inflation seems to have hit a barrier preventing it from making the ‘final mile’ to the Fed’s target of 2%. PCE and Core PCE have both stalled in the 2.5-3.0% zone[1], and CPI inflation remains stubbornly above 3%, with the latest headline rate (3.4%) higher than in June last year.[2]
The statement issued by the Fed following the latest meeting on May 1st essentially acknowledged that progress on inflation had stalled.[3] Chairman Jerome Powell, while asserting that he was still expecting inflation to decline further this year, added, “My confidence in that is lower than it was because of the data we’ve seen”.
Looking at the Fed’s actions as well as its words, it is worth noting that the Fed plans to slow down its Quantitative Tightening (QT) program from June onwards. This is a sign of (highly cautious) optimism that inflation is stabilizing.
The resilient economy
The initial fear was that prolonged higher rates would not only cool down the economy but potentially tip it into recession. While yields in the bond market appear to indicate that recession is likely in the next 12 months[4], the immediate economic data is less conclusive.
True, unemployment ticked upwards from 3.8% to 3.9% in April[5], which caused some to believe that the tide was turning. However, unemployment remains historically low, and as the Bureau of Labor Statistics noted in the same press release, the numbers have essentially remained unchanged.
One potential explanation for the continued strength of the labor market is that labor supply - thanks to high immigration, is driving activity as companies eagerly look to snap up new talent following the post-Covid hiring squeeze.[6]
Commentary from policy makers
The release of the minutes from the May meeting revealed that the committee is in some doubt as to whether rate increases are as impactful as they were in previous years.[7] It is possible, as some have speculated, that many consumer mortgages and corporate loans currently in effect were issued during the low rate period and hence are not affected by recent monetary policy.[8]
While Chairman Powell is on record stating that further rate increases are ‘unlikely’, various fellow committee members have since voiced opinions to the effect that there is no hurry to cut rates at the current pace of progress. At a talk on May 21st, Fed Governor Christopher Waller said that he would need to see “several more months of good inflation data” before contemplating the possibility of cutting rates.[9]
In January, the markets were expecting no fewer than six rate cuts over the course of the year, but these expectations have been radically revised downwards. That rates will hold steady at the coming June meeting is almost universally accepted (98.7% as of the time of writing[10]). Only one rate cut in November is currently forecast this year.
Conclusion
As Bank of America analysts wryly commented in a recent note to clients, “Nothing changes until something changes”[11]. Either the Federal Reserve must give in to pressure - commercial, political, or otherwise - and reverse course, or the corporate and consumer markets must give into the pressure of higher rates and slow their activity.
The Federal Reserve cannot forecast the future any more than the markets can, but it is doing what it can - maintaining a steady nerve and a firm sense of purpose. We advise our clients to adopt a similar attitude when planning their financial future: while we can’t control the markets or world events, we can control how we react to them.
[1] Bureau of Economic Analysis
[2] Federal Reserve Bank of St. Louis