Key Takeaways
- Economic data took a back seat to financial conditions in the Fed's policy decision-making at its Oct. 31-Nov. 1 meeting.
- Futures market pricing now indicates less than a 25% chance for a rate hike in December or January.
- However, we think economic data will drive decision-making once again in the policy meeting in December. We continue to expect one more rate hike of 25 basis points in December.
Economic Data Takes A Back Seat To Financial Conditions
The Federal Reserve held its policy rate steady at a 22-year high of 5.25%-5.50% at its latest policy meeting on Oct. 31-Nov. 1. The American economy has had generally stronger-than-expected employment and GDP growth, and inflation progress has slowed since the September meeting. But still, the Fed was inclined to hold rates because financial conditions have tightened sharply. Equities had been down 8.7% since July 31, the last 25-basis-point hike, and, more importantly, the benchmark risk-free 10-year Treasury yield had risen about 100 basis points to nearly 5%.
The policy statement acknowledged the impact of financial conditions on interest rates, indicating that "tighter financial and credit conditions...are likely to weigh on economic activity." In September, the phrase was "tighter credit conditions…are likely to weigh on economic activity..."
Whether the Federal Open Market Committee (FOMC) is done with rate hikes will depend on a few factors--namely, progress on lowering inflation, and the state of labor market and financial conditions. For now, we maintain our previous assumption that there will be one more rate hike of 25 basis points in December.
For 2024, we continue to expect economic growth to come in below trend and inflation to improve toward the Fed's 2% target. The Fed will hold the policy rate steady through the first half of the year, letting passive tightening of real rates continue through disinflation, after the assumed December hike. It's then likely to begin cutting rates in the second half of 2024 as unemployment starts to rise and inflation nears 2%.
Tighter Financial Conditions Substituted For A Rate Hike
During his press conference following the meeting, Chair Jerome Powell stressed again that the FOMC is "squarely focused" on the dual mandate and is "strongly committed" to bringing inflation down to the 2% goal. But when answering a question on how the higher bond yields affect the FOMC's thinking, he indicated that "persistent changes in financial conditions" can have implications for monetary policy.
But two conditions need to be met for the rise in long bond yields to substitute for rate hikes. First, the tighter conditions need to be "persistent," and second, the rise in longer-term rates cannot simply be a function of expected Fed policy actions. It is a high bar for rate hike substitution in the near future.
We agree with Chair Powell that the rise in the longer-term rates has been more to do with the term premium than with expected Fed policy actions (see chart). One of many reasons the term premium has increased is the heavier-than-expected issuance of Treasuries on the long end. To that end, announcement effects are important. On July 31, the Treasury surprised the market with a plan that pointed to increasing the size of its longer-dated note and bond auctions (rather than shorter-term bills).
In contrast, this week, the Department of the Treasury's quarterly refunding documents deemphasized the issuance of longer-term bonds. Instead, the recommendation from the Treasury Borrowing Advisory Committee shifted more weight to short-term Treasury bills. 10-year Treasury yields plunged yesterday, on the Treasury's refunding announcement that moderated the pace of supply increases of long-term bonds. All said, the jump in the 10-year Treasury yield that we saw since July 31 from the issuance channel may have run its course for the time being.
Too Early For The Fed To Relax
Yet, Chair Powell signaled more hikes might be needed given ongoing employment strength and the lack of confidence that inflation is sustainably on a path toward 2%. We see the November meeting's decision as a "hawkish pause" despite the financial market's "dovish" outlook on the FOMC. Following the FOMC meeting, the futures market trimmed risks for another 25-basis-point hike by the Jan. 31 meeting, to about 27% from about 33% previously. The market is also pricing in cuts by June.
Whether the FOMC is done with rate hikes will depend on a few developments. One is the progress of inflation toward the 2% goal, which slowed in the last couple of months. Monthly core inflation was up, with core services, excluding the housing component, ticking up again. Another, and relatedly, is labor market conditions--supply and demand are becoming more balanced but still have room for improvement.
Additionally, the Fed will be monitoring financial conditions. Between now and then, we don't expect financial conditions to tighten more than they already have, but we do expect employment and inflation numbers to come in stronger than what the Fed deems consistent with the 2% inflation rate.
It is more likely that economic data will once again be the driver of policymaking in the coming weeks. Although, expansion of Middle East conflict and a U.S. government shutdown midway through November are key risks that may make the policymakers lean toward pausing yet again in December.
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. S&P Global Ratings' analysts use these views in determining and assigning credit ratings in ratings committees, which exercise 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, San Francisco + 1 (212) 438 6009; satyam.panday@spglobal.com |
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