Fed pauses rate hikes while signaling a tightening bias

REAL ECONOMY BLOG | June 14, 2023

Authored by RSM US LLP

The Federal Open Market Committee on Wednesday kept its policy rate in a range between 5% and 5.25% while signaling that it will most likely hike the federal funds rate by 25 basis points at least twice before the end of the year.

This implies a possible policy peak of 5.75% later this year. Given that we think that the recent bank turmoil and the issuance of Treasury notes following the debt-ceiling standoff are equivalent to 65 basis points of tightening, this implies a current “proxy rate” of close to 6% and a proxy policy peak of 6.5% later this year.

While the FOMC chose not to hike rates, both the tone of the policy statement and the dot plot, or the FOMC members’ forecast of interest rates, implied a hawkish tightening bias through the remainder of the year.

We expect the next rate hike to occur at the July 25-26 meeting as policymakers await developments in the labor market and on the inflation front.

With inflation likely to drop notably even as the labor market remains strong, the four remaining meetings this year will remain live events, with the possibility of rate hikes. This should for all intents and purposes remove any chance of a rate cut this year.

Next year, though, is a different story. Given that the Fed’s latest Summary of Economic Projections, issued on Wednesday, implies a recession next year, its forecast now indicates close to 100 basis points of rate cuts next year. The Fed’s dot plot now forecasts a median rate of 4.6% at the end of next year and 3.4% at the end of 2025.

Summary of Economic Projections

The FOMC, in its Summary of Economic Projections, upgraded its forecast on both growth and employment this year.

The central bank now expects the pace of growth to reach 1% this year, up from a forecast of 0.4% previously, and the unemployment rate, currently at 3.7%, to increase to 4.1%, lower than its previous forecast of 4.5%.

The FOMC is now forecasting a growth rate of 1.1% next year and 1.8% in 2025. The Fed expects the unemployment rate to rise to 4.5% next year and stay there through the end of 2025—suggesting that the Fed forecasts a recession next year.

We base this analysis on the staff projection of close to a 1% increase in the unemployment rate over the next 18 months.

The long-run growth trend did not change and remained at 1.8%, while the Fed’s estimate of full employment of 4% did not change.

On the inflation front, the Fed brought down its forecast of the personal consumption expenditures index—which the Fed considers its best long-term predictor of inflation—to 3.2% from 3.3% previously. The Fed then expects that rate to slow to 2.5% next year and to 2.1% in 2025.

The Fed’s long-run target remains 2%. The core PCE inflation estimate is now expected to arrive at 3.9% compared to the 3.6% posted in March.

The FOMC forecast indicated that core PCE, which excludes the volatile food and energy categories, will ease down to 2.6% next year and to 2.2% in 2025.

Policy statement

The Fed has reached a point where it wants time to ascertain the lagged impact of past rate hikes. In our estimation, the key paragraph in the policy statement addressed that desire:

“Holding the target range steady at this meeting allows the Committee to assess additional information and its implications for monetary policy. In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

The policy statement started off by saying that “recent indicators suggest that economic activity has continued to expand at a modest pace. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated. The U.S. banking system is sound and resilient.

Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.”

The Fed is quite cognizant of the impact of tighter credit conditions and the rising cost of doing business, and that its tightening will result in rising unemployment and overall economic activity despite the upgrade to its forecast on gross domestic product.

While the economy remains resilient given the twin shocks of elevated inflation and rising interest rates, it is realistic that the economy will slow down as 15 months of rate increases are felt. For this reason, the Fed still expects the economy to fall into recession next year.

Powell’s remarks

Federal Reserve Chairman Jerome Powell sought to underscore the hawkishness implied by the statement and Summary of Economic Projections by pointing out the Fed’s commitment to restoring price stability.

The question-and-answer session of the news conference allowed Powell to explain why the Fed paused its rate increases—it had to do with the degree (500 basis points) to which it has increased the policy rate—and was careful to reiterate the Fed’s sensitivity to the evolving conditions across the economy in general and the financial sector in particular.

Powell also went out of his way to note that the Fed wants to observe a decline in inflation for the services excluding housing category, which is up by 4.6% from a year ago and has a three-month average annualized increase of 2.9%.

The Fed believes that inflation in the non-housing service sector of the economy is an important factor in the setting of wages, which the Fed wants to see fall back toward 3%.

The takeaway

The Fed put forward a hawkish narrative around the economy. It is mindful about the impact of its financial tightening, which it expects to cause an increase in unemployment later this year and into next year.

The policy rate is almost certainly going to increase to a peak of 5.75% by the end of the year with a degree of financial tightening that is notably higher because of tighter lending standards and a disruption to the Treasury market caused by the debt-ceiling standoff.