Final Thoughts Ahead of Fed Day
Things I am thinking about in preparation for tomorrow’s FOMC decision:
- Higher for longer. I think the Fed wants to pull attention away from individual rate decisions and toward the expected path for rates. A key part of this message is that the inflation data drives policy decisions, and with inflation likely to remain high, rates will be held higher for longer compared to a typical cycle. This doesn’t mean that growth doesn’t matter, but the Fed has in the past had the luxury to quickly react to slowing activity because inflation was low and stable near the inflation target. With inflation well above target, and with the Fed still seeing upside risks to inflation and inflation expectations, the Fed cannot place as much weight on growth as it did in recent cycles. The result is that rate hikes will likely continue even if the unemployment rate rises (indeed, that scenario is already embedded in the SEP), and the Fed will resist rate cuts until inflation is clearly on track to return to target.
- The end of guidance? A story making the rounds is that the Fed will not give very specific guidance about its next move. Via the Wall Street Journal:
The Fed is likely to raise its federal-funds rate by 0.75 percentage point, to a range between 2.25% and 2.5%, at this week’s meeting. While further rate rises are likely this year, Mr. Powell might be less specific about his expectation for their sizes, according to analysts.
I believe that Federal Reserve Chair Jerome Powell is not likely to give hard guidance about the outcome of the September meeting but will keep 75bp on the table. As noted above, I think the focus shifts to the path of rates. At the same time, I have heard the “end of guidance” stories before, and my experience is that it never lasts long. Speakers can’t help themselves. Relentless questions from financial journalists inevitably lead one or more comments on the next move, and those comments create a narrative that other speakers feel forced to respond to. Eventually, leadership will come in to clarify the situation because no one likes the markets to be surprised on FOMC day (a point proven in the run-up to the last meeting). There will always be some sort of guidance.
- Dismissing the inverted yield curve. At the Sintra conference, Powell dismissed concerns about the yield curve, saying it’s “not a top-line worry.” Since then, the curve has inverted further, but I see little room for Powell to now suggest that it is a concern given the inflation numbers. Even if it is a recession indicator, Powell has been clear that while the Fed doesn’t intend to create a recession to reduce inflation, it won’t shy away from causing a recession if that is required to restore price stability. Elevating the importance of recession worries implied by the yield curve would make the Fed appear dovish, and I don’t think that’s a signal the Fed wants to send.
- Will the next move be “expeditious?” The Fed has been hiking rates at an “expeditious” pace to bring policy rates to neutral. Now that policy rates are near neutral, what is the rational for further “expeditious” rate hikes? And if future rate hikes are not done expeditiously, are they “measured”? I think the Fed could retain the term “expeditious” by saying it still needs to “move expeditiously to bring rates into a restrictive setting,” but that would suggest a 50bp or 75bp hike likely at the next meeting, which would contradict the idea that the Fed wants to provide less guidance. At the same time, dropping “expeditious” might be interpreted as putting 25bp on the table for September, and I think market participants would view that as dovish. The Fed could also retain “expeditious” by saying that its higher inflation forecast pushes neutral to the upper end of estimates (3%). I believe that if the Fed wants to lose the “expeditious” language, it will need to replace it with something equally hawkish.
- Credibility. The Fed appears to have set a high bar for a rate pause, and an even higher bar for rate cuts – the Fed needs clear and compelling evidence from a series of inflation reports before it entertains a more dovish policy direction. That matches with the higher for longer rate story we have been telling. But is this a credible commitment given that inflation is a lagging indicator? Is there a pain point at which the Fed makes a dovish pivot before
- The terminal rate. Clients have asked if Powell will give any insight into the terminal rate. I don’t think there is much information for him to give. The Fed doesn’t know if the terminal rate is 3%, or 4%, or higher. I think Powell will say the terminal rate is whatever is necessary to restore price stability, and at best he can point to the last SEP to illustrate both the general direction and the range of potential outcomes. If Powell were to say that, in his opinion, the terminal rate is higher than he believed in June, that would be a hawkish signal that would focus on the rate path and not necessarily require a 75bp rate hike in September.
Bottom Line: I am confident that the Fed wants to send a hawkish message this week. The easy path to sending that message is to set up another 75bp hike in September, but I don’t think the Fed will to do that if, as I suspect, the goal is to reduce the level of guidance while creating a hawkish path that does not require an additional super-sized hike. It might be a tricky space to navigate; we have always said the Fed will face a communications challenge when it comes time to set the stage for stepping down from 75bp. I feel like there is an extra degree of uncertainty around how Powell delivers the Fed’s message and market participants’ interpretation of that message.