A New Chapter? Deconstructing The Latest FOMC Rate Decision

This article delves into the implications of this interest rate increase. We'll examine the economic data, market reactions, and potential impact on the U.S. economy and investors worldwide.

What action has the Fed taken?

The 0.25% increase brings the federal funds rate to a target range of 4.5-4.75%, the highest in over 15 years. 

The Fed is also continuing its quantitative tightening (QT) program to slow inflation by reducing the money supply. Since June last year, its balance sheet has decreased by approximately $463 billion as maturing debt has not been reinvested. 

Background and Rationale

The latest 0.25% hike was smaller than the previous increases of 0.50% and 0.75% over the past 12 months. This indicates that the decade-high inflation that emerged in 2022 is receding. The Consumer Price Index has been falling every month since its peak of 9.1% in June 2022 to 6.5% in December, its lowest in over a year. 

Fed Chairman Jerome Powell noted various macroeconomic factors supporting this trend, including modest economic growth, weaker housing market activity, and subdued investment by businesses.  

The labor market remains an area of caution. Although wage growth slowed toward the end of 2022,  job openings increased in December with 1.9 positions per unemployed worker.  Data published after the meeting reinforce concerns, with unemployment decreasing to a 53-year low. Monthly wage growth also held steady at 0.3%, although cooling year on year (to 4.4% from 4.6% in December). 

What will the Fed do next?

While acknowledging that the “disinflationary process” has begun, the Fed intends to continue to raise rates as inflation remains far above the 2.0% target. Chairman Powell indicated that “a couple more” increases are under discussion, bringing the final rate above 5% in May, in line with official predictions in December. 

However, Chairman Powell indicated a “path” to the target inflation level that does not involve significant economic hardship. A “soft landing” would be an ideal scenario where inflation is dampened without triggering a deep recession.

How did markets respond?

Despite initial jitters upon the announcement of the new target rate, markets responded favorably to the Chairman’s guarded optimism.[1] Although the message said that it would be “very premature to declare victory,” its positive tone gave investors some clarity on rate actions and hope for the economy overall.

The market expects two more 0.25% increases in March and May.[2] While opinions are divided on whether rates will reduce by year-end, rates will remain high for a longer period.

Some still point to the need for caution, noting two risks: 1) recession is still a real possibility, and the effect of the steep rate rises from last year have yet to come, and 2) over-optimism could renew inflation, forcing the Fed to raise rates still higher.

Conclusion

The release of quarterly economic projections at the next Fed committee meeting on March 21-22 may give the markets more clarity.

 Meanwhile, the Fed appears to be cautious in both words and action. Investors should steer a similar course: observe market signs and interpret them cautiously.

[1] Federal Reserve - https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
[2] Statista - https://www.statista.com/statistics/273418/unadjusted-monthly-inflation-rate-in-the-us
[3] Federal Reserve - https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20230201.pdf
[4] Bureau of Labor Statistics - https://www.bls.gov/news.release/pdf/eci.pdf
[5] New York Times - https://www.nytimes.com/2023/02/01/business/economy/labor-jolts-report-layoffs.html
[6] Bureau of Labor Statistics - https://www.bls.gov/news.release/pdf/empsit.pdf
[7] Federal Reserve - https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20221214.pdf
[8] FT.com - https://www.ft.com/content/03b5354d-ad3c-4bfd-b1cc-c64d46dfdf28
[9] CME FedWatch Tool - https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html

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