FOMC Snapshot: One and Done?

While it is clear that the Fed will raise the target federal funds rate by 25 basis points to a range between 5.25% and 5.50%, it is less clear whether this will end the hike cycle.

The Federal Open Market Committee meets Tuesday and Wednesday.

In its latest summary of economic projections, most FOMC members saw rates of at least 5.50%, suggesting at least two more hikes this year.

Even with more tightening, “we may not touch this recession,” said Judith Raneri, vice president and portfolio manager at Gabelli Funds.

The market priced a quarter-point rise for this meeting, noted Blake Gwinn, head of US rates strategy, and Izaac Brook, US rates strategy analyst at RBC Capital Markets. “The Fed, tellingly, made no attempt to oppose these market prices during the blackout period.”

The only change they anticipate in the post-meeting statement may “be a slight loosening of language around inflation” as the FOMC takes a “data-dependent approach for upcoming meetings.”

No market movement is expected from the meeting, Gwinn and Brook said, with the only possible market driver being Fed Chairman Jerome Powell’s press conference, “but we don’t think much will be revealed here.”

It’s too early to project the September move or break, they said, with a possible clue coming from the Jackson Hole symposium next month.

However, Morgan Stanley believes in the one-and-done scenario. “The slowdown in jobs and inflation raises the bar for the Fed to resume its hike after July, and we continue to expect it to be extended before making the first 25 basis point cut in 1Q24.”

If the Fed acknowledges that inflation is easing or removes the word strongly from its statement – the committee remains very watchful of inflation risks – “it could be taken as a dovish surprise by market participants,” Morgan Stanley said.

“Policy delays and loan terms should feature prominently at the meeting,” said BNP senior US economists Andrew Schneider, Yelena Shulyatyeva and Andrew Husby. “The latest iteration of the Senior Loan Officer Opinion Survey, which we expect to tighten further, should help inform a growing internal debate about whether previous rate hikes have yet to be passed through to the economy.”

Although they see a tightening bias remaining in place, knowing that policy is close to a sufficiently restrictive level and that future moves will depend on the data, July’s rise will end the cycle, they said.

“The deceleration in economic activity, the lagged effects of previous rate hikes, the tightening of lending conditions in the banking sector and greater evidence of disinflation will, in our view, be more significant in the second half of 2023 and will eventually dilute the conviction of further tightening,” they said.

Others think the Fed will mimic the summary of economic projections and hike again after this meeting.

Judith Raneri, Vice President and Portfolio Manager at Gabelli Funds, said: “We are looking at an additional 50 basis points, which will be affected by returns across the yield curve. Not so much in the six years, but definitely in the two and three years, because those are the most influential in Fed policy. However, the three to six months will always be cheaper from here.

Although the Fed started raising rates late, she said, the economy held up. But even with more tightening, she said, “we may not be able to touch this recession.”

“We’ll probably see another 50 basis points in rate hikes, probably in the form of two 25-point moves,” said Chris Ainsworth, CEO of New York-based tech wealth management platform Pave Finance, despite thinking “they’ve raised rates too much already.”

“It’s not a function of raising rates — it’s a function of the Fed managing forward-looking inflation expectations,” he said. “They got it wrong a year ago, so they must be too aggressive to make sure forward inflation expectations come back down.”

The Fed is about to make a policy mistake, according to Ryan Swift, US bond strategist at BCA Research. “The more difficult question is whether the Fed will make this mistake this year by continuing to rise in a moderating inflation environment, or next year by keeping the policy rate in restrictive territory for too long. For now, we lean towards the latter scenario.”

Core inflation should slow enough for the Fed to hold out after this month. “At the end of the day, we see the Fed’s big policy mistake coming next year when it keeps rates too high for too long, even as standard policy rules start suggesting rate cuts,” Swift said.

The Fed is not expected to raise rates this month, said Bryce Doty, senior vice president and principal portfolio manager at Sit Investment Associates. Inflation is falling and more and more people are entering the labor market.

“As a result, logistics supply shortages dissipate with the inflation that those shortages were causing,” he said. “Inflation is crossing the critical level where it will be below the fed funds rate, indicating even more restrictive Fed policy than just above a neutral 3% interest rate.”

The bond market, through the “strongly inverted yield curve,” Doty said, “is shouting at the Fed, ‘We know you’re raising rates, but that’s a mistake! “”

Although the Fed held rates at the last meeting, it raised “expectations for growth, inflation and jobs” for the rest of the year, said Gary Pzegeo, head of fixed income at CIBC Private Wealth US.

“They sent a message to the markets to expect, one, the pause to be short, very short, and two, to be prepared for higher peak interest rates than they had previously announced,” he said.

Gary Pzegeo, Head of Fixed Income at CIBC Private Wealth US

“They’ve sent a message to the markets to expect, first, the pause to be short, very short, and second, to prepare for higher peak interest rates than they’ve previously announced,” said Gary Pzegeo, head of fixed income at CIBC Private Wealth US.

The rise should not be the start of “another prolonged move higher in short-term rates, and we still view the tightening cycle as nearing its end,” Pzegeo said. With core inflation too high for the Fed, “jobs growth is slowing and we expect wages to eventually follow.”

In addition, questions about loans remain. “Higher rates are eating into corporate cash flow more and lower valuations in areas such as commercial real estate are expected to weigh on credit quality going forward,” he added. “Taken together, these constraints could accelerate the slowdown in wage growth and broader measures of inflation, and we expect the Fed to follow by easing pressure in the rates market.”

While the recession remains its base case, starting and ending next year, Peter Berezin, chief global strategist at BCA Research, sees three scenarios where a recession can be avoided.

First, if the unemployment rate of 3.6% turns out to be full employment. “If that were the case, the Fed wouldn’t need to keep GDP growth below potential.”

The second is if full employment is above 4%, “but potential growth is accelerating so much, perhaps due to AI, that real growth doesn’t need to fall significantly to create some slack in the economy,” Berezin said.

The last solution would be for full employment to be above 4%, but “potential growth is not accelerating, but nonetheless, the Fed is able to calibrate monetary policy enough to achieve a soft landing.”

Although he puts the recession risk at 75%, it will most likely be mild, with a 20% chance of moderate to severe.

While the indicators — an inverted yield curve and collapsing major economic indicators — point to a deep recession, they have improved recently, noted Thornburg co-chief investment officer/chief executive Jeff Klingelhofer.

If recession were averted, it would be the first time “where those signals flashed red, and we dodged the recessionary bullet,” he said. The reason for this would be the strength of the labor market and the still high savings due to the COVID pandemic.

“This labor market strength has been the thorn in the side of the Fed as it has supported consumer spending and demand even as prices have risen,” Klingelhofer said. “Despite rising underlying labor costs, business revenues have grown beyond labor costs, meaning businesses have been willing to continue to hire and retain workers. So far, higher rates are not immediately transmitted through the economy to destroy demand and drive down prices.”

Eventually, he said, the labor market will weaken and recession will ensue. “We continue to believe this will happen later this year or early 2024. What is important from an investment perspective is that our projected timing does not align with market behavior. We do not believe the market is pricing in the recession appropriately, either in the consumer or business space, which could lead to market disruptions and opportunities for investors.”