Fed holds rates, but hints at one more rate hike in 2023

21 Sep 2023 , 10:41 AM

Rate hikes, if any, were expected to happen only the November meeting. That was the impression given out by the Fed and that was also what was manifested in the CME Fedwatch. In its Fed statement issued on September 20, 2023, the US Federal Reserve held rates static in the range of 5.25% to 5.50%. However, the Fed statement made it amply clear that the Fed was not done with rate hikes and hinted at one more rate hike in 2023. More importantly, the Fed has cut its guidance for rate cuts in 2024 from four rate cuts to just 2 rate cuts. That means; rates would still remain above 5% through the year 2024.

Despite the fact that the Fed is very serious about its communication, there was a gnawing fear in the market that the Fed would front-end rate hikes in September in response to a sharp spike in inflation. In fact, consumer inflation has steadily risen from 3.00% in June to 3.20% in July and further to 3.70% in August 2023. Of course, through this period, food inflation and core inflation had been trending lower while most of the pressure came from energy inflation. That is not surprising considering that Brent crude prices are now well above the $90/bbl mark. Most likely, the Fed would crystallize its view on the November rate hike after seeing the data reading on PCE inflation, to be announced later this month.

The Fed continues to underline that its battle against inflation is not done yet. However, what emerges from the statement is that in future, the battle would not be fought by hiking rates but by holding rates at elevated levels for longer. That is evident in the Fed dot plot guidance of just 2 rate cuts in 2024. It must not be forgotten that in the last 2 months, the Fed has diverged sharply from its inflation target of 2% and is now a full 170 bps away. The Fed is justified in believing that inflation could get out of control, if the Fed did not intervene decisively and quickly by hiking rates.

CME Fedwatch has turned more hawkish post the minutes

One way to look at the Fed outlook from a market perspective is the CME Fedwatch, which captures probabilities of rate levels after each Fed meet over next 1 year.

Fed Meet	350-375	375-400	400-425	425-450	450- 475	475-500	500- 525	525-550	550-575	575-600
Nov-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	71.6%	28.4%	Nil
Dec-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	53.4%	39.4%	7.2%
Jan-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	51.2%	40.0%	8.8%
Mar-24	Nil	Nil	Nil	Nil	Nil	Nil	7.2%	49.6%	35.6%	7.6%
May-24	Nil	Nil	Nil	Nil	Nil	1.8%	17.9%	46.1%	28.5%	5.7%
Jun-24	Nil	Nil	Nil	Nil	0.6%	7.3%	27.6%	40.0%	20.6%	3.8%
Jul-24	Nil	Nil	Nil	0.3%	3.5%	16.1%	33.0%	31.6%	13.3%	2.3%
Sep-24	Nil	Nil	0.1%	2.0%	10.2%	25.0%	32.2%	21.9%	7.4%	1.1%
Nov-24	Nil	0.1%	1.1%	6.1%	17.5%	28.6%	27.1%	14.7%	4.3%	0.6%

Data source: CME Fedwatch

What do we read from the CME Fedwatch probability shifts? Firstly, with the Fed rates already at the range of 5.25%-5.50%, another 25 bps hike this year now looks like a worst case scenario. That has also been confirmed by the Fed statement. The CME Fedwatch is not factoring in peak rates at beyond 6% for now. Secondly, the downside in the form of rate cuts is, at best about 50 bps to 75 bps from current levels and anything beyond that looks unlikely, even in 2024. It clearly shows that, going ahead, the Fed plans to use static rates at elevated levels, as a proxy for hiking rates. After all, the Fed cannot afford to ignore growth for too long, especially at a time when sceptics are crying hoarse about a recession.

What we read from the September Fed Policy Statement

The gist of the Fed statement on September 20, 2023 is that another rate hike was in the offing in 2023 and also that the rate cuts in the year 2024 would be more muted. The Fed is entering a tough phase, where its leeway to tackle inflation by hiking rates is gradually reducing. It still needs to manage inflation expectations and hence cannot be seen to not be in control of the situation. Here are some key takeaways from the Fed statement. 

1. Essentially, the Fed has held interest rates steady, while indicating that it expects one more hike before the end of the year. While the Fed has not officially confirmed, it does look like the range of 5.75% to 6.00% could be the peak rates that the Fed is currently thinking about. That is why, the Fed has decided to compensate that with fewer rate cuts in 2024. Rate cuts will be limited to 2 rather than 4 in the coming year.

    

2. The Fed appears to be a lot more optimistic on the economy as it has hiked its GDP growth projections for 2023 to 2.1%. A lot will depend on the third and final estimate of Q2 GDP that will be out in the end of September. Early indications reveal that GDP growth above 2% should not be a major challenge for the US economy.

    

3. In its statement, the Fed also highlighted that tightening of the economy is also happening in other ways. For instance, since the Fed started unwinding the bond portfolio of the Fed in June 2022, it has reduced its bond holdings by $815 billion. That should partially help to magnify the impact of rate hikes, in the task of containing inflation and bringing it down to the 2% mark.

    

4. The Fed has indicated that another rate hike may be the end of the rise for this round. Hence, the most likely scenario is that the Fed would hike rates by 25 bps in November and that would mark peak rates. From then on, the Fed would calibrate how long it holds rates at elevated levels. Fed is likely to restrict rate cuts to just two in 2024. Rates are already at the highest level in last 22 years. 

    

5. The gist of the Fed statement is still hawkish with the bias towards more restrictive policy and a higher-for-longer approach to interest rates. In his post policy conference, Jerome Powell has once again underlined that the Fed would prefer to see more rapid progress in controlling inflation and a decisive and reliable move towards 2%. In fact, the dot plot has hinted at average rates at around 5.1% by end of 2024. The median rate projection for 2025 is also up by 50 bps from 3.4% to 3.9%. So, hawkish for longer.

    

6. One thing that emerges from the fed statement is that the long term rate is being seen at around 2.9% in 2026, which should be the sustainable rate. That is substantially higher than the post-COVID rates and also well ahead of the neutral rate of 2.5%. The neutral rate is the level at which the interest rates does not have a negative impact on GDP growth. It means, Fed expects inflation to be a long term challenge.

    

7. However, analysts have pointed to an anomaly in the entire situation. The Fed has projected a scenario wherein inflation will steadily cool down, but the labour market will continue to remain historically tight. However, analysts have pointed out that these two are normally incompatible. Tight labour markets result in higher wages and that is generally a driver of inflation and could be at cross purposes with the fed intent. 

    

8. The positive news comes from the growth front as the Fed has upped its GDP forecast for 2023 to 2.1%, largely in line in first two quarters. Also, the 2024 GDP projection has also been raised by 40 bps to 1.5%, which should offer a consolation to the Fed that despite such persistent tightness created in the market by the Fed, the growth impulses of the US economy have not really been impacted. Even the term used to describe economic growth is “Solid” compared to “Moderate” in previous policies.

    

9. Since June 2022, the Fed has allowed $95 billion of maturing bonds to roll off rather than being reinvested. That has reduced the US Fed bond book from $9 trillion to about $8 trillion. That is compressing liquidity and magnifying the impact of the rates cuts, although the impact on growth is still not visible. 

    

10. In a sense, the latest Fed statement marks a shift to a more balanced view as compared to the singularly hawkish view in the past. With the US economy in a delicate position, amidst persistent warnings about a recession, the Fed appears to have seen a shift in thinking, which is evident in the latest policy statement. It has moved from the fear of doing too little to contain inflation to a concern about doing too much to impair the growth impulses. That is not showing, but Fed would rather err on the side of caution. Nothing would be a bigger feather in the cap for the Fed officials, if they are able to bring down inflation, at the same time ensuring a soft landing for the US economy.

     

11. To sum up, the Fed has also highlighted some risks to its assessment. Energy prices have surged by 30% in 3 months and energy is not just about the energy index but the strong externalities on other sectors too. The other risk is that unemployment at 3.8% is still very close to full employment so the labour market remains tight. It remains to be seen, if these two factors can really sabotage the fight against inflation.

The Fed has pointed out that while consumer spending has been robust, consumer balance sheets have not been so. Most consumers in the US appear to be spending even as their savings have diminished and credit card debt has crossed the $1 trillion mark for the first time ever. How this will eventually impact the economics of demand, prices and growth remains to be seen. 

What should the RBI read from the September Fed statement?

It may be too early to call it the end of the rate hikes in the US, but the Fed is certainly very close to the top. There is now credible evidence that Fed could be done with another 25 bps hike and then the action will shift to longer pause and fewer rate cuts. However, India has its own share of problems, especially the consumer inflation at 6.83% in August 2023. The RBI is now a good 283 bps away from its inflation target of 4% and this has been entirely caused by food inflation. The impact of fuel inflation is yet to be fully factored in, as prices continue to be regulated in India. But topping of rates in the US, is a cause for relief.

RBI had effected its last rate hike in February and has kept rates on hold over the next 3 MPC meetings in April, June, and August 2023. In the meantime, food prices have led the headline inflation once again to above the upper tolerance limit of the RBI at 6%. The RBI is still ambivalent on whether it should hike rates, but the Fed pause will give the RBI the leeway to pause in October also. For now, the policy statement by the Fed gives some breathing space for the RBI. However, domestic inflation is the big issue for the RBI to address.