United States
As widely expected, the Fed executed its fourth 75bp hike in a row. This constitutes 3.75% of hikes since March, taking the upper bound of the Fed Funds Rate to 4%.
We expect a smaller 50bp hike in December, representing a planned “downshift” rather than a strategic “pivot”. However, we see the risks are skewed toward another 75bp hike, depending on upcoming data releases.
Although we expect modest hiking to follow in 2023, we believe investors should remain cautious of further volatility as the Fed manages markets expectations around its policy downshift.
No Fed “pivot” into year end
Until yesterday, markets had been been pricing in rate cuts in 2023, even though the Fed itself is not guiding toward cuts until 2024 (Figure 1).
Figure 1: Market pricing is already pricing in cuts next year1
We see the prospect of rate cuts in 2023 unlikely. Today, the Fed’s opening statement offered no indications of such a strategic shift, as it was largely unchanged from last month, even retaining language stating the Fed “anticipates that ongoing increases in the target range will be appropriate”.
Chair Powell also stated that it was “premature to think about pausing” rate hikes and “we have a way to go”. He also indicated the central bank’s estimate of the “terminal rate” may need to be revised up next month.
The Fed did add a statement relating to the “amount of future increases” being determined by factors such as “the cumulative tightening of monetary policy”. We believe this is setting up markets to expect a downshift in the size of rate hikes, but not a pivot away from hiking further.
Although the consensus is for another 50bp hike in December (in line with the Fed’s guidance), we believe Fed Chair Powell is keen to avoid being too committal, leaving the potential for a 75bp hike on the table, while guiding markets in the interim.
Economic conditions do not justify a Fed pivot
The Fed is conscious of the fact that, so far, there have still only been tentative signs that its rate hikes have been feeding through into the real economy, making 2% inflation still a distant prospect.
In the labor market, the unemployment rate remains at record-equaling lows of 3.5%, even as the prime-age labor participation rate has recovered to pre-pandemic levels, at 83%2.
Further, yesterdays’ job openings data for September even rose by 4.25% in September, meaning there are two jobs available for every unemployed person, well above pre-pandemic norms of 1x to 1.2x. This is a metric the Fed watches closely, and it indicates no significant loosening of the labor market yet.
Figure 2: There are two jobs available for every unemployed person3
The Fed will nonetheless need to downshift its pace and magnitude of hikes
In line with its recent guidance, we currently expect the Fed to hike much more modestly in 2023, compared to the blistering pace of 2022.
Such a downshift is potentially justified because the Fed is inching ever-closer to the policy rate implied by a modified version of the Taylor Rule (Figure 3).
Figure 3: Fed rate policy is catching up with rates implied by the Taylor Rule4
Additionally, the Fed’s statement highlighted its consideration for “the lags with which monetary policy affects economic activity and inflation, and economic and financial developments”, so is willing to proceed with a degree of caution as its prior hikes take full effect.
The Fed is also watching excess savings. During the pandemic, consumers amassed $2.5trn of excess savings relative to the pre-pandemic trend (due to fiscal stimulus and economic restrictions), but now they are down to their last ~$900bn5 (due to inflation and pent-up spending demand). Those at the lower end of the income distribution are already feeling the pinch, reflected by credit card balances rising to 8% above pre-pandemic levels6. The Fed will be watching this dynamic closely to understand the path of consumption into next year.
Market volatility may be inevitable as the Fed communicates its downshift
The Fed’s rate hikes have had more impact on financial assets this year than the real economy. This is reflected by tightening financial conditions over the year (Figure 4).
Figure 4: The Fed will aim to keep financial conditions tight to help ensure monetary policy is transmitted to the real economy7
The upside is that tighter financial conditions (i.e. higher rates, credit spreads, lower equity valuations etc), help the transmission of tighter monetary policy into the real economy.
However, there is a danger that, as the Fed downshifts to a slower pace for tightening, the Fed will inadvertently loosen financial conditions if markets rally in the aftermath.
The challenge for the Fed will be to communicate to the market its desire to keep monetary policy and financial conditions tight over the medium term. It may do this by continuing to deploy hawkish rhetoric. Perhaps that is why Powell clear to message that the end of its hiking cycle is not yet in sight.
In our view, further bouts of market volatility appear highly likely as the Fed continues to manage market expectations.
“Peak hawkishness” may be here, but investors need to be careful as the Fed prepares to downshift
We expect the Fed is getting closer to completing its hiking cycle, after which we expect rates to remain on hold for some time.
This is starting to reflect the monetary policy trajectory across the globe. Australian and Canadian central banks recently hiked less than expected, indicating that “peak hawkishness” is becoming an increasingly global phenomenon.
However, we believe investors need to avoid mistaking this for a pivot to rate cuts, particularly given sticky inflation dynamics in the US. Further volatility is likely as the Fed makes a tricky transition to lower rate hikes over the coming months. In our view, fixed income investors need to maintain discipline and stay cautious into year-end.
