Fed holds status quo on rates in November 2023 FOMC meet

2 Nov 2023 , 11:44 AM

Fed holds rates, but with adequate safeguards

On November 01, 2023, the Fed statement again held status quo on rates. But, to get a real perspective, let us take a quick look back at how rate cycle has evolved. In the ten FOMC (Federal Open Markets Committee) meetings between March 2022 and May 2023, the Fed hiked rates by a total of 500 basis points with a minimum hike of 25 bps in all the meetings. Out of the 10 meetings between March 2022 and May 2023, the Fed had hiked by 75 bps on 4 occasions; by 50 bps on 2 occasions and by 25 bps on 4 occasions. 

That adds up to a full 500 bps rate hike by the Fed in an aggressive (and almost desperate effort) to control rampant inflation. However, the real story was after that. In the 4 FOMC meetings subsequent to May 2023, the Fed held status quo on 3 occasions and hiked rates by 25 bps on just one occasion in July. In short, the Fed has surely given up on its aggression in the hope that the lag effect of cumulative rate hikes would be instrumental in taming inflation. At least, that is the hope for the time being!

Growth or price stability: that remains the challenge

In the last four meetings of the FOMC, what has changed is not just the quantum of rate hikes, but also the tone and the language of the Fed. From an aggressive all-out attack on inflation, the Fed is now trying to balance growth and inflation control. The outcome of this shift has been positive for the US economy. After growing at around 2.1% in the first two quarters of 2023, the US economy grew by a whopping 4.9% in the third quarter ended September 2023. This solid economic growth combined with tight labour conditions have ensured that the progress on inflation has also slowed. 

After touching a low of 3% inflation in July 2023, the US inflation has been persistently above that level. The PCE inflation in September was at 3.4% with the 2% target still a good 140 basis points away. The Fed statement on November 01, 2023 has emphasised that while it has been sensitive to the growth engine, the battle against inflation was far from over. It remains to be seen what form this battle takes, although it is very likely that the Fed would continue with its stance of pausing at elevated levels for a long time and back-ending any rate cut chances for now.

CME Fedwatch is less hawkish than the Fed language

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
Dec-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	85.2%	14.8%	Nil
Jan-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	78.1%	20.6%	1.2%
Mar-24	Nil	Nil	Nil	Nil	Nil	1.2%	14.8%	67.2%	16.9%	1.0%
May-24	Nil	Nil	Nil	Nil	Nil	7.5%	41.2%	42.0%	8.9%	0.5%
Jun-24	Nil	Nil	Nil	Nil	3.9%	24.9%	41.6%	24.9%	4.6%	0.2%
Jul-24	Nil	Nil	Nil	2.4%	17.1%	35.4%	31.0%	12.1%	1.8%	0.1%
Sep-24	Nil	Nil	1.5%	11.2%	28.0%	32.6%	19.7%	6.1%	0.8%	Nil
Nov-24	Nil	0.8%	6.8%	20.5%	30.8%	25.6%	12.1%	3.1%	0.4%	Nil
Dec-24	0.5%	4.4%	14.9%	26.4%	27.5%	17.6%	6.9%	1.5%	0.2%	Nil

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 almost looks like a worst case scenario with a fairly low probability in the next few months. That is something on which the CME Fedwatch and the Fed communication appears to be in sync. However, there is a major area of disagreement between the Fed statement and what is manifested in the CME Fedwatch. For example, the CME Fedwatch is hinting that rate hikes may be done and dusted in this round. However, the Fed has included enough safeguards in its statement to indicate that it would not hesitate to hike rates should the need so arise.

The second dichotomy is on the rate cut front. The Fed is not willing to commit anything more than 50 bps rate cut by end of 2024. That means, the Fed rates would still average above 5% by December 2024. On the contrary, the CME Fedwatch appears to be getting more aggressive on the rate cuts front and is also pegging the Fed rates to go as low as 4.50% over the next one year. How have such dichotomies been addressed in the past? The experience has been that the Fed takes its communication very seriously and would refrain from making any forwards looking statement it is not sure of at this point. In the past, there have been numerous occasions when such differences have arisen, but eventually the CME Fedwatch view has tended to veer towards the Fed view. 

What we read from the November Fed statement

The Fed held rates at the level of 5.25%-5.50% but with adequate warnings that it would not hesitate to hike rates should the inflation challenge so demand. Here are some major takeaways from the Fed statement.

1. The big news was not the status quo on the rates but an upgrade of the Fed assessment of GDP growth for 2023. This assumes importance after the Bureau of Economic Analysis (BEA) upped the GDP growth estimate for the third quarter to 4.9%. This upgrade also, effectively, means that the risk of hard landing may be off the table for now and a soft landing looks the more likely option. But, more about that later!

    

2. However, the statement on inflation by Jerome Powell was quite telling, “The process of getting inflation sustainably down to 2% has a long way to go.”. In fact, the Fed chair, Jerome Powell emphasised that central bank had not made any decisions yet for its December meeting and hence second guessing would be pointless. This apparently refers to the CME Fedwatch, which has already ruled out rate hike in December meet.

    

3. On the subject of rate reductions, Powell stressed that the Federal Open Markets Committee (FOMC) was not even considering or debating rate reductions at this point with the inflation still about 150 basis points away from the long term target of 2%. However, Powell did add that the rather delicate risk around the Fed doing too much or too little to fight inflation had now become more balanced.

    

4. However, many Fed watchers have a more cautious approach in contrast to the smugness of the CME Fedwatch. The view is that with 2 consecutive meetings seeing a pause, the potential risk of the rate bar moving higher may have become a reality. In short, with inflation high and growth robust, the Fed may now have the luxury of looking at higher terminal rates and give itself more upside rate room to contain inflation. 

    

5. The Fed has specifically pointed out that while the growth outlook had substantially brightened after the first advance estimate of Q3 GDP in late October, the jobs data had apparently moderated to some extent. While the jobs situation is still strong with unemployment at just about 3.9%, the labour market is not as tight and under-supplied as it was a few quarters back. Having said that, the non-farm payrolls had grown by 3,36,000 in September, which is much higher than street estimates.

    

6. The big news in the last few weeks has been the rapid rally in the 10 year bond yields to 5% mark, before it relatively normalized. However, the bond yields are still more than 100 bps higher than the June levels. According to the Fed statement, this is an indication that the financial conditions, apart from the credit conditions, had also tightened. Companies are finding it tough to raise funds at a reasonable cost and that remains the big concern for the Fed, and probably the reason that coaxed the committee to maintain status quo on rates this time around.

    

7. On the future trajectory of rates, the Fed statement (and even Powell in his post policy conference) highlighted that it was still determining the extent of additional policy firming that it may need to achieve its goals. While inflation progress is visible on a yoy basis, the challenge is to handle the last mile from the current 3.5% levels to 2% target. The one big challenge for that target to be achieved remains the labour data. For instance, the supply demand mismatch in the labour market may have reduced in relative terms; but there are still 1.50 available jobs for every available worker.

    

8. One thing that emerges from the Fed statement is that, for now, it would stick to its “Hold Higher for Longer” strategy with respect to rates. Fed will try to redefine hawkishness as a longer pause than as rate hikes. Also, it will magnify the impact by putting of rate hikes deeper into the future. 

Clearly, the Fed has not fully given up on its hawkish stance, although it is now being more sensitive to the financial and credit risks of its actions. In a sense, the November policy was supposed to be a shift, but nothing of that kind was really visible in the statement. 

How Fed explained the spike in bond yields

One of the things that the markets were expecting from the Fed was an explanation of the rise in bond yields in the US markets. The Fed has proffered several reasons for the same.

• Inflation staying higher for longer than expected and the stickiness of core inflation has been a key factor in surging bond yields.

   

• Persistent hawkishness by the Fed was another key reason for the surge in bond yields, especially its last statement of higher for longer and back-ending of rate cuts.

   

• One factor we have all seen play out is the yield spike in the US being triggered by a fall in bond prices. That has been attributed to falling interest in US treasuries.

   

• Above all, one major reason for the spike in bond yields was the normalization of the yield curve as investors started demanding higher rates on longer term maturities. 

Bond yields need to be looked at, especially in the light of the last two factors with the premiumization of long term bonds being the most obvious reasons.

What does the Fed statement mean for the RBI?

RBI had effected its last rate hike in February and has kept rates on hold over the next 4 MPC meetings in April, June, August, and October 2023. The good news for the RBI is that the consumer inflation has fallen sharply by over 240 bps in the last 2 months. That does away with any immediate risks to inflation and the need to hike rates urgently. The core sector has stayed above 8% for four months in a row and that is likely give the leeway to the RBI if the need so arises.

While the RBI members in the MPC are still hawkish, the MPC overall is still ambivalent on whether it should hike rates. For now, a pause looks most likely. The Fed minutes will give the RBI the leeway to pause in December also and that should take away any immediate concerns on the monetary policy front. For now, the policy statement by the Fed gives breathing space to the RBI. However, domestic inflation, rising global bond yields and a highly vulnerable Indian rupee would be the X-factors to watch out for.