A focused Fed

By staying on hold at its Oct. 31-Nov. 1 meeting, the Fed is betting that the 550 basis-point worth of hikes over the past 19 months will be sufficient to eventually bring inflation back down to its 2% target. While monetary policy works with long and variable lags, the central bank is playing a dangerous game. If inflation stops falling and begins to creep higher, the policymakers’ decision to hold the 5.25-5.50% target range could enable inflation to become more entrenched in business and consumer psychology, ultimately leading to an even higher terminal rate and a more severe pullback in the economy.

The addition of tighter financial conditions to its post-meeting statement was a nod to the significant bear steepening of the yield curve in recent months and an acknowledgement that higher long-term interest rates may have obviated the need for additional hikes. When asked if the recent surge in long-term rates substitutes for an additional hike, Chair Jerome Powell said it depends on two things. First, is the increase sustainable? Second, is the rise due to fundamental factors such as expectations for stronger economic growth, or to projections the Fed will raise the fed funds rate in the future? If the latter, the Fed would not view a rise in long-term yields as a stand-in for additional tightening, especially given the potential it won't deliver on the expected hikes.

The stock and bond markets interpreted Powell’s comments as indicating that the Fed is done raising rates and staged significant rallies in the aftermath of his press conference. Whether or not the Fed is actually done hiking will be determined by the path of the labor market and inflation in coming months.