On November 2, the Fed at its regular meeting raised the federal funds rate to 3.75-4.00%. The meeting was accompanied by a press conference by the head of the Fed, Jerome Powell, and, at first glance, his speech was extremely aggressive. However, should we trust this rhetoric and expect a rate hike above 5%?
- There is no feeling that inflation is declining. The labor market is strong, and we are ready to allow some increase in unemployment.
- Our policy should be more restrictive: we will continue to raise rates and significantly reduce our balance sheet.
- It is premature to think or talk about the suspension of rate hikes yet.
- Incoming data since our last meeting suggests that the final level of interest rates will be higher than previously expected.
Ways to increase the rate
There are three components of the rate in monetary policy tightening: the speed, level and time of holding the rate.
- Speed. Powell made a clear comment: “After the work done on the restriction of monetary policy, the issue of speed becomes less important. It would be appropriate to slow down the pace of rate hikes (in December and February)”.
In other words, this means that the rate hike in December by 0.75 p.p. is unlikely. So far, the market (see CME FedWatch Tool) with a 50/50% probability expects an increase of 0.50 or 0.75 percentage points in December.
- Boost level. Powell announced that “the maximum level of interest rates is likely to be higher than previously expected”.
Today the market expects the rate to reach 5.00-5.25% in March. However, this scenario is unlikely to materialize in reality.
- Nothing new was said about the holding time, the wording remained the same: “Restoring price stability will probably require maintaining restrictive policies for some time.”
Will the Fed raise rates above 5%?
A rate above 5%, especially if it persists for a long time, will hit the US economy hard: both the real sector and financial institutions. Leading statistics suggest that we will see a decline in US GDP in the fourth quarter of this year and the first quarter of next. Already today we are witnessing a historical contraction of the debt market. The Fed understands this: According to Powell, “financial conditions have tightened significantly in response to restrictive action.”
More importantly, with such a historically rapid tightening of monetary policy, time is needed for economic agents to adapt to new financial conditions. This slowdown/pause is essential for the economy, including evaluating the effect of efforts to curb inflation.
The Fed understands this and comments: “In determining the pace of future increase in the target range, we will take into account the cumulative tightness of monetary policy and the lags that it has on economic activity and inflation.”
Available data allow us to predict that inflation in the US will decline from October. The consumer price index (CPI) has been declining from July to September. The core consumer price index (excluding energy and food) has been rising, but historically it follows the main index with a time lag.
What to expect
Against the backdrop of deteriorating financial and economic conditions and – likely – future positive inflation data, it can be assumed that rate levels of 4.50% -4.75% (rather than 4.50%) will be a ceiling in containing the monetary policy. Powell’s aggressive rhetoric should be seen more as an attempt to justify the authority of the Fed, which allowed inflation to jump.
An indirect argument in defense of the fact that the threshold of 5% will not be crossed was the reaction to the debt market’s speech by Powell. It showed no decline, although the growth in interest rates primarily hits debt securities.
The stock market, which is dominated by private investors, has declined at the same time – and downward pressure may prevail until December. However, if the inflation data is positive, we may see the S&P 500 and other indexes rise even before the December meeting.
Nick Klenov, financial analyst at Raison Asset Management