Fed Plans to Move Slower, But Go Further
November 3, 2022
The Federal Reserve voted unanimously yesterday to increase its target for the Federal Funds rate by 75 basis points. The upper end of the Fed Funds target range now sits at 4 percent. The committee has increased interest rates by three-quarters of a percentage point in each of its last four meetings, after doing so just once before this year. Though historic, yesterday’s increase was not a surprise. The market was already positioned for a 75 basis point increase. Instead, most of our focus was on how the Fed communicated its expectations for policy over the rest of this year and into 2023.
The most significant change to the committee’s policy statement was the introduction of new language stating that the committee would take into account the “cumulative tightening of monetary policy” and the “lags with which monetary policy affects economic activity.” We interpret these changes as a sign that the committee will soon slow the pace of interest rate increases. By explicitly considering the cumulative change in interest rates, the committee is acknowledging that the rapid change in interest rates to date could disturb markets irrespective of the actual level of rates. Similarly, by accounting for the lag between a change in monetary policy and when its impact reaches the real economy, the committee is tacitly endorsing proceeding more slowly while tightening policy over the next few months.
However, Fed Chair Jerome Powell made clear in his press conference that the assessment of the terminal interest rate has increased since the September meeting. Though short-term rates have increased sharply into restrictive territory, measures of core inflation remain stubbornly high. There also remains a significant imbalance between labor demand and supply which is driving wage growth faster than what would be consistent with the 2 percent inflation target. The committee’s most recent set of economic projections released in September indicated a median forecast for the year-end 2023 Fed Funds level of 4.6 percent. Though this is not necessarily the median expectation for the terminal rate (rates could possibly be cut before year-end, based on FOMC year-end forecasts), we expect this median forecast to be revised higher when the next set of economic projections are released following the December FOMC meeting.
On balance, the market took the communications as hawkish. The S&P 500 closed the day down 2.5 percent and the US Dollar rose. This was clearly not the policy pivot that some market participants hoped to see. The prospect of a higher terminal rate is certainly a net negative for US equities. However, there are some positive takeaways. First, the market was already priced for roughly a 5 percent terminal rate. That means the market was ahead of the Fed before the meeting and therefore will have less catching up to do to the Fed’s new expectation. Furthermore, by increasing rates at a slower pace the Fed is reducing the risk of a policy mistake. Like a driver looking for a street number on a poorly lit road, the Fed is planning to keep moving forward but slowing down to try to avoid traveling past its destination.
Our base case for the December meeting is a 50 basis point increase. The committee will have a lot of new data to consider over the next six weeks including two labor market reports (released on November 4 and December 2) and two CPI releases (November 10 and December 13). If this data shows little impact from the accumulated rate increases, the committee may instead opt to increase rates by 75 basis points for the fifth consecutive meeting.
David Allen, CFA, CFP
Chief Investment Officer
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