Key Takeaways
- The FOMC's 25-basis-point rate hike on July 26 was widely expected, but the odds of further hikes this year will depend on the path of inflation.
- We still think the July hike could be the last in this cycle, though better-than-expected second-quarter GDP growth makes us less confident.
- We expect the Fed will lean toward a "skip" in September to buy more time to assess the need for another hike.
- Given the Fed's messaging on restrictive monetary policy and our inflation outlook, we don't expect rate cuts before June 2024.
In a well-telegraphed move, the Federal Open Market Committee (FOMC) hiked its policy rate by 25 basis points to 5.25%-5.50% in its July 25-26 meeting, following the "hawkish pause" at its mid-June meeting. The decision to hike was unanimous among the 11 voting members of the FOMC. It also announced a continuation of its balance-sheet run-off.
Inflation Path Steers Odds Of Further Hikes
The post-meeting statement and Chairman Jerome Powell's press conference, taken together, retained a tightening bias that signals the possibility of an additional move higher later this year. Many FOMC participants had penciled in one more hike this year (after July) according to their own projections published at the mid-June meeting, and there's no indication softer inflation data for June (published mid-July) might have weakened their conviction.
This isn't surprising, given one month's favorable reading doesn't make a trend to rely on--especially when the pace of intermeeting economic activity expansion was upgraded to "moderate" from "modest," thus removing doubt at the margin. Second-quarter GDP growth, published this morning, came in at 2.4% annualized (versus 2.0% in the first quarter), affirming the Fed's upgrade of economic activity.
While the July decision was widely expected by market participants, they remain highly uncertain about the next move this year. Implied fed funds futures suggest only modest risk for further tightening at the Sept. 19-20 FOMC meeting, but chances for one at the Nov. 1 meeting were running around 37% as of July 27. Markets continue to price cuts starting in March 2024.
In S&P Global Ratings' latest economic forecast update (published late June), we penciled in the July rate hike as the last in this rate hike cycle. This was with the understanding that our forecasts for below-potential real GDP growth starting in the third quarter, better balance in labor demand and supply, a further slowing of core inflation, and rising downside risks to credit conditions from higher rates would keep the Federal Reserve on the sidelines. We are less confident about our June rate hike assumption today, on balance, after yesterday's FOMC statement and the higher-than-expected GDP growth in the second quarter, which suggests growth momentum is built in for the third quarter.
Our Fed assumption is at the mercy of the inflation path in the coming months as the committee remains highly attentive to inflation risks. It is still Fed officials' worst fear that disinflation stops prematurely. The data dependency mantra means the onus will be on the upcoming inflation and employment reports (two each between now and mid-September) to stay the Fed's hand.
Doors Left Open To Hikes And Skips
When asked if the slower pace of rate hikes meant the Fed would automatically pause at every other meeting, Chairman Powell batted down the idea of such a preordained "skip" in hikes. That means the upcoming meeting in mid-September is a "live" one. We suspect the doors were left open for additional rate hikes also to sell markets on the "hawkish hold" and limit any further easing in financial conditions, which would be counterproductive to the Fed's goals.
Come September, however, the Fed could easily justify another skip to buy more time to observe inflation, if disinflation continues its moderating trend at the core--excluding food and energy--averaging a monthly annualized pace close to 2%, as we expect. Or the Fed could hike again, if it deems core inflation is still far off the 2% mark and economic growth is running at or above potential. Chairman Powell noted that the Fed can afford to be "patient," given how far it has boosted rates, but will also stay "resolute" in the fight against inflation.
Our view is that the Fed will lean toward another skip in September to give itself more time (three months) to assess the need for an additional hike. If the labor market fails to weaken or core inflation fails to make the progress expected, another 25-basis-point hike would likely be on offer. As it stands, markets are giving this a slightly above one-third chance.
Do We Need To Do More?
This is the question FOMC members will be asking themselves at future meetings, according to Chairman Powell.
The monetary transmission mechanism (as seen in interest-sensitive mortgage demand, for example) may seem relatively blunted for now, but that doesn't mean it won't bite with passing time. A broad array of credit indicators have already started to signal as such; rising delinquency rates for credit cards and auto loans, default rates for high-yield and leveraged loans, and contracting demand for new business and consumer loans amid high interest rates indicate the July rate hike will apply more pressure on the U.S. economy.
The Fed entered the July meeting with data on the second-quarter Senior Loan Officer Opinion Survey in hand (published to the public next week), which Chairman Powell indicated pointed to further tightening in bank credit and softer loan demand. While a resilient U.S. labor market has enabled consistent consumer spending so far this year, the slowdown in credit could indicate high interest rates are catching up to the economy. We think the Fed will probably recognize in the coming months that this week's increase may work as the final one in this fine-tuning process to strike the right balance between disinflation and modest growth.
Hold Or Fold?
If our forecast is realized in the second half of the year, the disinflation (our forecast implies Personal Consumption Expenditures inflation of 2.9% year over year by December 2023) probably would not be enough for the Fed to declare victory and start cutting. But it would be enough to encourage FOMC members to hold while they wait for the effects of prior rate hikes to fully materialize.
After all, the monetary policy stance "hasn't been restrictive enough, for long enough," according to Chairman Powell. The real policy rate climbed to positive territory only four months ago, and only just recently, at 1.5%, has it become "meaningfully positive," i.e., above the central estimate of FOMC participants' longer-run 0.5%-1.0% neutral rate (neither restrictive nor stimulative, at steady state). It will press only deeper into restrictive territory--even if the Fed keeps rates unchanged--with every month that (expected) inflation decelerates. We do not anticipate the Fed will cut before June of next year.
The views expressed here are the independent opinions of S&P Global Ratings' economics group, which is separate from, but provides forecasts and other input to, S&P Global Ratings' analysts. The economic views herein may be incorporated into S&P Global Ratings' credit ratings; however, credit ratings are determined and assigned by ratings committees, exercising analytical judgment in accordance with S&P Global Ratings' publicly available methodologies.
This report does not constitute a rating action.
U.S. Chief Economist: | Satyam Panday, New York + 1 (212) 438 6009; satyam.panday@spglobal.com |
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