Will the Federal Reserve exit “in progress”? Or will that keyword remain in the central bank’s policy directive?
When the Federal Open Market Committee announces the results of its two-day meeting next Wednesday afternoon, such a seemingly inconsequential question could halt the course of interest rates.
The Fed’s policy-setting panel is confident of raising the federal funds target range to 4.50%-4.75%. That would represent a drop from the 25 basis point hike, the usual rate move until last year, when the FOMC played to catch up on normalizing monetary policy, which was previously too easy. The committee imposed four supersize 75 basis point increases in 2022 and then added a 50 basis point increase in December. (A basis point is 1/100th of a percentage point.)
At the time, the FOMC said it “expects continued increases in the target range to be appropriate.” Keeping the plural word “hikes” in the policy statement likely means at least two more 25 basis point hikes on March 21-22 and May 2-3. This would increase the fed funds target range to 5%-5.25%, in line with the median 5.1% single-point forecast in the FOMC’s most recent report. Summary of economic forecastsannounced at the December meeting.
But the market does not believe it. As you can see from the chart here, the Fed-fund futures market is pricing in only one increase at the March meeting. After keeping the rate target at 4.75%-5%, the market now expects a cut of 25 basis points to 4.50%-4.75%, a day after Halloween. That would put the key policy rate about half a point below the FOMC’s midyear forecast and 17 of the 19 committee members’ forecasts.
The Treasury market is also struggling with the Fed. The two-year note, the most sensitive to rate expectations, traded at a yield of 4.215% on Friday, below the lower end of its current 4.25%-4.50% target range. The peak of the Treasury yield curve is six months, where the TDI trades at 4.823%. From there, the curve slopes downward, with the 10-year benchmark at 3.523%. Such a configuration is a classic signal that the market sees lower interest rates ahead.
In recent weeks, a number of Fed speakers have spoken positively about slowing the pace of rate hikes, hinting at a 25 basis point hike on Wednesday. But they stuck to the message that monetary policy will remain on course to bring inflation back to the central bank’s 2% target.
Brean Capital’s veteran Fed watchers John Ryding and Conrad DeQuadros said it was too early to say if policy was restrictive enough to meet that goal, based on the latest reading of the central bank’s preferred inflation measure, the personal consumption expenditure deflator. Data released on Friday showed that the PCE deflator rose 5.0% year-over-year. So, after a likely Fed-funds hike next week, to a target range of 4.50%-4.75%, the key interest rate will still be negative when adjusted for inflation, suggesting that Fed policy remains easy.
Economists at Brean Capital expect Fed Chairman Jerome Powell will not repeat the central bank’s mistake of the 1970s, easing policy too soon, allowing inflation to pick up again. The latest inflation figures have fallen from four-decade highs hit last year, largely due to energy that surged during the pandemic and lower prices for goods including used cars.
But Powell highlighted non-housing core prices as key indicators of future price trends. The increase in the prices of non-housing services is seen to be mainly due to labor costs. Powell highlighted the tight job market, reflected in a historically low unemployment rate of 3.5% and new unemployment insurance claims below 200,000.
But in what BCA Research called an important speech, Fed Vice Chairman Lael Brainard noted that those non-housing services costs rose more sharply than labor costs, as measured by the Employment Cost Index.
If so, it can be concluded that these measures of inflation are likely to decline faster than the ECI as a result of narrowing profit margins. Anyway, fourth quarter ECI reading It will be released on Monday, the day before members of the Federal Open Market Committee meet.
Highlighting the lag between the Fed’s actions and their impact on the economy, Brainard was reported last week by the Washington Post as being on the short list to replace Brian Deese as head of the National Economic Council. If he gets to the White House, it will eliminate a key vote in favor of easing the pace of monetary tightening.
At the same time, even as the federal funds rate approaches restrictive levels, general financial conditions have eased. This is reflected in lower long-term borrowing costs such as mortgage interest; corporate credit, especially in the high-yield market, which has risen in recent weeks; stock prices rose smartly from October lows; sharply reduced volatility for stocks and fixed income securities; and the depreciation of the dollar is a huge boon for exports.
In any case, if the FOMC’s statement talks about “continuing” rate hikes, it will serve as a clue to the central bank’s thinking on future rates. Alternatively, the statement may emphasize that the policy will be data dependent.
If so, economic releases such as Friday morning’s jobs report and subsequent inflation readings will take on more import. A further slowdown in nonfarm payrolls growth from 223,000 in December to 185,000 in January is the consensus call among economists. The December Job Openings and Labor Turnover Survey, or JOLTS, arrives Wednesday morning, just in time for the FOMC to consider.
Powell’s post-meeting press conference will also send important signals. He’s sure to be asked if working conditions are tight following job cuts by tech companies. And he’s sure to be questioned about the wide gap between what the market sees for rates and what the Fed predicts in its December Summary of Economic Outlook, which won’t be updated until March.
The only thing that is certain is that the debate on monetary policy will continue.
type At Randall W. Forsyth randall.forsyth@barrons.com
