Hawkish pause

Bottom Line 

At Wednesday’s policy-setting meeting, the Federal Reserve executed a well-telegraphed pause, opting to hold the federal funds rate steady at a target range of 5.00-5.25%, after ten consecutive interest rate hikes over the past 15 months. But in a clear surprise to financial markets, the Fed predicted that it might raise interest rates twice more over the balance of this year, to further combat the growing dichotomy between sharp declines in nominal inflation and more gradual declines in the more important core inflation metrics.  

That suggests additional quarter-point hikes by the Fed at its upcoming meetings on July 26 and Nov. 1, sandwiching pauses on Sept. 20 and Dec. 13, which would bring the terminal interest rate to an upper band of 5.75% by year end. That would represent a 22-year high in interest rates, as the Fed has orchestrated the most rapid series of rate hikes since the 1980s, in its bid to reverse the worst inflation in the U.S. economy in more than 40 years.  

“Immaculate disinflation and pivot?” Not! The Fed’s actions this week clearly threw cold water on the market’s consensus view that inflation would soon plunge to the central bank’s 2% target and the Fed would immediately shift gears and begin cutting interest rates.  

• 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 4.0% in May 2023, a rapid decline of 5.1% over 11 months. 
• Core CPI, which excludes food and energy prices, declined from a 40-year high of 6.6% last September to 5.3% in May 2023 for a more modest decline of 1.3% over the past eight months.
• Nominal Personal Consumption Expenditures (PCE) index similarly declined from a 41-year peak of 7.0% last June y/y to 4.4% in April 2023, marking a decline of 2.6% over 10 months. 
• Core PCE (the Fed’s preferred measure of inflation) has declined from a 39-year peak of 5.4% in September 2022 to 4.7% in April 2023, for a more muted drop of 0.7% over the last seven months. The Fed’s target for this metric remains at 2.0%.

So inflation clearly peaked last year and is starting to recede, but nominal inflation is falling at a much faster pace than core inflation. That suggests that the Fed will remain hawkish over the second half of this year, because the Fed is more focused on bringing stickier core inflation to target.  

“Allowing inflation to get entrenched in the U.S. economy is the thing that we cannot allow to happen,” said Fed Chair Jerome Powell during Wednesday afternoon’s press conference.

SEP update – higher inflation, mixed picture on growth and unemployment The Fed published the quarterly update of its Summary of Economic Projections on Wednesday, raising their core PCE inflation forecast from 3.6% to 3.9% by the end of this year; not changing their 2.6% estimate by year-end 2024; and going from 2.1% to 2.2% by the end of 2025. So, by the Fed’s own admission, it will be another two and a half years before they’ve successfully approached their inflation target.  

The Fed also increased its forecast for real GDP from 0.4% to 1.0% in 2023; and it lowered both 2024 from 1.2% to 1.1% and 2025 from 1.9% to 1.8%. Its forecast for the official unemployment rate (U-3, now at 3.7% in May 2023) declined from 4.5% to 4.1% in 2023 and from 4.6% to 4.5% in 2024.  

Phillips’ Curve trade-off So the Fed’s trade-off between inflation and unemployment appears to be alive and well. As the Fed continues to contemplate two more rate hikes in the second half of this year, it expects core inflation to gradually recede from four-decade highs to a level close to target by the end of 2025. But the price of admission is an increase in the rate of unemployment from a half-century low of 3.4% in April 2023 to 4.5% next year. In the Fed’s 110-year history, we’ve never experienced such a sharp increase in the unemployment rate without the economy falling into recession. Yet this cycle, the Fed expects GDP growth to trough at 1.0% this year and 1.1% in 2024. Is the Fed optimistically whistling past the graveyard? 

Bond market inversions highlight growing recession risk The significant inversion of three important yield-curve relationships, which historically have been reliable recession indicators, suggest that the bond vigilantes are becoming increasingly concerned about the growing risk of recession in the U.S. economy, perhaps over the next year or so: 

• Fed funds to 10s – with the upper band of the fed funds rate still at 5.25% and benchmark 10-year Treasury yields at 3.77%, this yield curve is inverted by nearly 150 basis points.
• 2/10 yield-curve – with two-year Treasury yields at 4.73% and 10 year at 3.77%, this inversion has expanded recently to nearly 100 basis points. 
• Three-month/10 year – with three-month Treasury bills yielding 5.20% and 10 year at 3.77%, this inversion has expanded to 143 basis points. 

Bank lending and commercial real estate To compound this problem of higher-for-longer interest rates, banks have tightened their lending standards for households and businesses and reduced their lending volumes in the aftermath of the forced, high-profile closures of Silicon Valley and First Republic, among other banks. Overlaying that with the slow-moving train wreck of the commercial real-estate industry potentially exacerbating these concerns, we expect economic and corporate earnings growth to slow.  

Serious case of Fear of Missing Out Amidst these worries, however, the S&P 500 continues to soar, hitting a new 14-month overbought cycle high today, up more than 27% from last October’s cycle low.  In our view, investors are suffering from Fear of Missing Out regarding the potential power of artificial intelligence, and they are indiscriminately bidding up a narrow basket of technology stocks, with little regard for valuation. As we’ve seen in past market cycles, that strategy continues to work until it doesn’t.