Goldilocks and the Federal Reserve

Bottom Line 

The Federal Reserve poured cold water on the popular “Immaculate Disinflation and Pivot” thesis at its policy-setting meeting on Wednesday. The Fed voted to keep interest rates unchanged at a 22-year high. But it signaled it would likely orchestrate one more hike this year and then hold at that level until at least the second half of 2024 before considering a pair of quarter-point cuts. Importantly, policymakers updated their quarterly Summary of Economic Projections (SEP), in which they are now projecting stronger economic growth and employment, with a continued gradual decline in core inflation. That explains why the odds of a soft-landing next year have improved.

The pause that refreshes The Fed skipped a hike this week, opting instead to hold the federal funds rate steady in a target range of 5.25-5.50% after 11 interest rate hikes over the past 18 months. We expect another quarter-point hike on November 1. That would bring the terminal interest rate to an upper band of 5.75% by year-end, up from near zero in March 2022. This would be its most rapid series of hikes since the 1980s, in its bid to reverse the worst inflation in the U.S. in more than 40 years. We expect the Fed to pause on December 13 and remain on hold until the back of half of 2024, before beginning to cut rates. 

Inflation continues to decline While inflation clearly peaked last year and is declining, nominal Personal Consumption Expenditures (PCE) inflation is falling four times faster than core inflation: 

• Nominal retail CPI inflation spiked from 1.4% year-over-year (y/y) in January 2021 to a 41-year high of 9.1% in June 2022, but it has since fallen to 3.7% in August 2023, a decline of 5.4% over 14 months. 
• Core CPI (which excludes food and energy prices) declined from a 40-year high of 6.6% last September to 4.3% in August 2023, for a more modest decline of 1.3% over the past 11 months. 
• Nominal PCE declined from a 41-year peak of 7.0% last June y/y to 3.3% in July 2023, marking a decline of 3.7% over 13 months. 
• Core PCE (the Fed’s preferred measure of inflation) has declined from a 39-year peak of 5.4% in February 2022 to 4.2% in July 2023, for a drop of 1.2% over the last 17 months. The Fed’s target for this metric remains at 2.0%. 

SEP update improves: 

• Core PCE inflation The FOMC reduced its forecast from 3.9% to 3.7% by the end of this year; no change in its 2.6% estimate by year-end 2024; increased its estimate from 2.2% to 2.3% by the end of 2025; and initiated a 2.0% forecast for 2026. So, it could be another three years before the Fed successfully achieves its core inflation target. 
• Real GDP It more than doubled in the projections from 1.0% to 2.1% in 2023; and it raised its 2024 estimate from 1.1% to 1.5%; but its 2025 estimate was unchanged at 1.8%. It initiated a 2026 forecast of 1.8%.
• Unemployment The unemployment rate was 3.8% in August 2023. The Fed is forecasting that it will remain at that level (down from its previous 4.1% estimate) by year-end 2023 and reduced its estimate from 4.5% to 4.1% in each of 2024 and 2025. It initiated a 4.0% estimate for 2026.
• Dot plot The FOMC voted to keep one more quarter-point rate hike in its forecast for 2023, to a range of 5.50-5.75% and raised its 2024 estimate to a range of 5.00-5.25% from 4.50-4.75%, which implies only two rate cuts next year, compared with its forecast for four cuts in June. It raised its 2025 estimate to a range of 3.75-4.00% from 3.25-3.50% in June, which implies five more rate cuts in 2025. 

Risks remain Despite this rosier outlook, Fed Chair Jerome Powell said during his post-meeting presser that the Fed is not without economic concerns: 

• Monetary policy Its impact on the economy from sustained higher interest rates and a shrinking Fed balance sheet from $9 trillion in April 2023 to $8.0 trillion today has still not been fully felt in the economy.
• Soaring energy prices Crude oil (West Texas Intermediate, or WTI) has surged by 46% over the past six months to $94 per barrel, and lagging retail gas prices at the pump have risen by 25% since December to $3.90 per gallon. 
• Rising wages The ongoing United Auto Workers (UAW) strike (in the wake of generous labor union settlements with the three legacy airline pilot unions, UPS workers and West Coast dock workers, among others) could result in elevated wage inflation. 
• Impending government shutdown The federal debt has risen from $26 trillion to $33 trillion over the past three years (a record debt-to-GDP ratio of 125%), which could result in Congress failing to reach a budget agreement by Oct. 1.
• Student loan debt Starting in October, 40 million borrowers will begin to repay an average of $400 per month. While that amounts to less than 1% of GDP annually, lower-wage borrowers may feel pressured in light of declining excess savings balances and rising credit card delinquencies. 

Yield curves remain inverted Significant yield-curve inversions have been reliable indicators of a slowing economy, and several currently in play suggest the bond market is concerned about the growing risk of recession:

• Fed funds to 10-year With the upper band of the fed funds rate still at 5.5% and benchmark 10-year Treasury yields at 4.44%, this yield curve is inverted by 106 basis points. 
• Three-month/10-year With three-month Treasury bills yielding 5.43% and 10s at 4.44%, this inversion is at nearly 100 basis points. 
• 2-year/10-year With 2-year Treasury yields at 5.12% and 10s at 4.44%, this inversion is at 68 basis points. 

Financial markets are spooked Since mid-July, benchmark 10-year Treasury yields have soared from 3.75% to an oversold 4.50% this morning (highest level since 2007), with no meaningful technical resistance before 5%. Similarly, the S&P 500 has declined by about 6% over the past eight weeks to an oversold 4,320, which is beginning to reverse the powerful 21% rally we enjoyed starting the new year. The "Big Eight" technology stocks are disproportionately succumbing to profit taking. We’ve been anticipating an 8-12% correction during the August-October period, so this recent pullback could have legs into the Fed’s November 1 meeting.

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