Jul 18, 2023|Market Insights- 3 min
At the last meeting on June 13-14, the Federal Open Markets Committee (FOMC) paused a series of rate increases that began in March last year, holding them at 5% - 5.25%, the highest level in 15 years.
At the next July meeting, the first of four remaining sessions in a precarious year for the U.S. economy, the Fed is expected to raise rates again.
This article explores the implications of the above on investors.
The economic backdrop
Since it became clear that the high inflation of 2021 was not “transitory” as assumed initially, the Fed has been in a continuing battle to dampen price growth by raising the cost of borrowing and decreasing the supply of money.
The gradual decline of inflation since rate hikes began, despite the continued growth in jobs and the economy, indicated that the policy of the Fed was working. The mini-banking crisis that affected a small number of banks earlier this year also appeared to have been contained.
The minutes of the June meeting show that while some members favored raising rates by another 0.25%, the rate hike was withheld until the effects of former increases are clearer.
The projections of the Fed, which reflect the opinions of individual members in the so-called “dot-plot” (below), forecast a median year-end rate of 5.6%, suggesting two further rate hikes in 2023. Rates are not expected to decline until 2024, with a long-run target in the region of 2.5%.[1]
Source: CME FedWatch
The latest data
The latest jobs data released on July 7 show that jobs are still growing—albeit at a slightly slower pace than expected—with 209,000 openings in June.[2] Unemployment declined to 3.6% (vs. 3.7% in May) while wages continued to grow (4.4%), beating expectations (4.2%).[3]
These figures may indicate that the economy still needs “cooling.” Wage growth, for example, may be passed on to consumers in the form of higher prices while higher-earning consumers may be able to absorb these price changes—leading to a potential upward spiral.
Against this, the latest inflation report released on July 12 showed that headline annual inflation declined from 4% in May to 3% in June,[4] driven partly by steep drops in the price of gasoline (-27.1%) and airfares (-18.9%) compared to a year before. This brings the inflation of the consumer price index (CPI) almost in line with the two-decade average before the Global Financial Crisis.[5]
Source: U.S. Bureau of Labor Statistics
Core inflation (which excludes food and energy) decreased more modestly from 5.3% in May to 4.8% in June. Although well above the target of 2%, it is the slowest monthly increase since August 2021.[6] Housing costs are the largest contributor to inflation, and rent is growing more modestly and set to decline further in the months ahead.[7]
At the time of writing, the CME FedWatch analysis shows a 94.2%-strong consensus that rates will increase again by 0.25% on July 26, with a majority predicting that this will hold until year-end—contrary to the latest forecast of the Fed for two further increases.
Conclusion
The effects of interest rates may take months or years to be felt in the wider economy, shrouding the trajectory in uncertainty.
Chicago Fed President Austan Goolsbee believes we are on a “golden path” to a recession-free victory over runaway inflation.[8] Meanwhile, Wall Street bears see a recession just around the corner in the yield curve.[9]
Meanwhile, Fed Chairman Powell said shortly after the last meeting that the economy “has a tendency to do something different” than policymakers expect.[10]
Given the continuing tightening by the Fed and the uncertain macroeconomic outlook, a prudent asset allocation strategy would include high-quality fixed income instruments, such as investment-grade bonds, and private debt, while remaining agile to take advantage of any opportunities that may arise.
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