Fed Not Thinking About a September Pause
It has been quite the swing in market sentiment over the past few weeks as contemplation of a 75bp rate hike gave way to speculation that the Fed will pause in this cycle as early as the September meeting. We think neither scenario is likely. Our baseline remains that the Fed will hike rates 50bp in each of the next two meetings while September stands as an opportunity for the Fed to transition back to 25bp rate hikes if the data allows. We are skeptical that the data will break in the Fed’s favor by September, but that is where the debate stands. Federal Reserve Chair Jerome Powell was very clear earlier this month that he doesn’t expect the Fed to pause until there was clear and compelling evidence that the Fed was on a path to restore price stability, and it is very unlikely that such evidence will emerge this year.
The minutes of the May FOMC meeting revealed that meeting participants focused on restoring price stability to an economy caught in an inflationary boom:
In their consideration of the appropriate stance of monetary policy, all participants concurred that the U.S. economy was very strong, the labor market was extremely tight, and inflation was very high and well above the Committee’s 2 percent inflation objective. Against this backdrop, all participants agreed that it was appropriate to raise the target range for the federal funds rate 50 basis points at this meeting. They further anticipated that ongoing increases in the target range for the federal funds rate would be warranted to achieve the Committee’s objectives.
Note the emphasis, the economy is “very” strong, labor markets are “extremely” tight, and inflation is “very” strong. This is an unquestionably hawkish, and universally accepted, assessment of the economy. Moreover, there was broad consensus to not only continue raising rates, but to maintain 50bp increments through July:
Most participants judged that 50 basis point increases in the target range would likely be appropriate at the next couple of meetings.
As we have written, the Fed has not reached a consensus past July, but there is no sense that the Fed will pause after completing only 175bp of rate hikes, a position that would leave policy rates slightly below the lowest estimates of neutral. At the same time, the minutes didn’t mention discussion of 75bp. As we have also written, that was never a thing.
Some analysts combined the lack of direction past July with Atlanta Federal Reserve President Raphael Bostic’s recent dovish comments to speculate that the Fed would pause after hiking rates in July, and there has been further speculation that the Fed will hike only 25bp in July. We view both outcomes as very unlikely. Recall Bostic from earlier this week:
“I have got a baseline view where for me I think a pause in September might make sense,” Bostic told reporters Monday following a speech to the Rotary Club of Atlanta.
Contrast this with Powell from two weeks ago:
So as a policy maker, the way I’m thinking about it is that right now, we’re raising rates expeditiously to—what we’ve been saying, to a more normal level, which is something that we’ll reach maybe in the fourth quarter, but it’s not a stopping point. It’s not a looking around point. We don’t know with any confidence where neutral is. We don’t know where tight is.
Powell clearly expects rate hikes to continue into the fourth quarter, and he does not expect to pause at neutral. Powell has set a high bar to pausing in the cycle:
So I do think by the standards of central bank practice in recent decades, we’re moving about as fast as we’ve moved in several decades. But I guess the way I would say it is this: What we need to see is clear and convincing evidence that inflation pressures are abating and inflation is coming down. And if we don’t see that, then then we’ll have to consider moving more aggressively. If we do see that, then we can consider moving to a slower pace. And it’s going to be a judgment call that we make going forward as we carefully monitor incoming data, the evolving outlook—how are financial conditions changing? How are they affecting the economy? And that’s how I think about it.
Obviously, we weigh Powell’s comments much more heavily than Bostic’s. Powell will get what Powell wants, Powell wants to restore price stability, and Powell is willing to risk recession to restore price stability. We don’t think he will err on the side of caution in the fight against inflation, whereas Bostic would.
I think it is very unlikely the Fed will receive clear and compelling evidence that not only is inflation coming down, but also that inflationary pressures are abating, by the time of the September meeting. Note that these are two separate issues. I have argued that core-PCE inflation numbers will likely be better than the core-CPI numbers, and the wedge between the two could be sufficient to allow the Fed to transition to 25bp at the September meeting (watch tomorrow’s numbers). This would be consistent with inflation coming down. But abating inflation pressures is another issue. The Fed is not likely to stop hiking rates until it can see the labor market is no longer overheating. I think that wage growth needs to moderate by at least two percentage points before the Fed can see a clear path to restoring price stability. But given the momentum of the U.S. economy, and the fact that labor market indicators tend to lag, it is very unlikely to see substantial pressure coming off the labor market by the time of the September meeting. Sure, that could happen, but it is not within the range of most likely outcomes.
The Fed will continue to hike rates even as in some sense financial conditions have reached at least a plateau for the cycle. Forward guidance has been remarkably effective this cycle, and financial conditions have tightened well ahead of the actual monetary policy action. Now the economy needs to digest the recent financial tightening, and I think it is reasonable that Treasury rates two years and out and mortgage rates stabilize and trade generally sideways while market participants wait for the data to give direction on the next stage of the cycle. Meanwhile, the Fed will just be following through on the expected hikes already incorporated into existing financial conditions. In a sense, the Fed is almost out of play even though it is very much still in play. There will likely be an opportunity for another step up higher in long rates, but first we need to see that the economy can handle the tightening already put in place and that the Fed will need to continue pushing forward to find a path to price stability. We need data supportive of that story, and we just don’t have it yet.
Bottom Line: The near-term path of policy is sticky. The Fed expects at least two more 50bp rate hikes, and to continue with additional hikes through the end of the year. It is too early to contemplate a policy pause given the high bar Powell has established to justify such a move. Financial conditions, however, can stabilize while the impact of policy tightening works its way through the economy.