Today the Federal Reserve (Fed) raised rates by 75 bps, as expected. The post-meeting statement included one notable change. The Fed said it will “take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
In his press conference Fed Chair Jerome Powell discussed when, and under what conditions, the Fed plans to downshift the pace of rate hikes. A downshift in the pace of hikes remains likely for a number of reasons. First, the Fed has raised rates by a substantial amount this year. It will likely take some time for the full effect of those rate hikes to be reflected in the economic data. These lags are an important consideration as the Fed calibrates the relative weight of the incoming data versus the economic outlook when making its policy setting. Second, real rates are now positive across most parts of the yield curve. This has been a key metric for the Fed, and it is now clearly indicating that policy is “restrictive.” Third, the Fed is cognizant of the elevated risks around the globe, due to rapid tightening by other central banks, an ongoing military conflict and heightened uncertainty with regard to the direction of the Chinese economy. Each of these considerations—lags in the impact of rate hikes, positive real rates and elevated global risks—argues for a more moderate pace of rate hikes going forward.
While Powell was clear on the reasoning for a downshift in the pace of hikes, he did not make any commitments about the timing. For reference, the previous round of Fed forecasts had suggested that officials expected a downshift either late this year or early next. Ahead of today’s meeting, the market’s assessment of the probabilities was similar. After today’s meeting, this still seems to be the base case, both for the Federal Open Market Committee (FOMC) and for the market. If anything, the market probabilities shifted a bit toward a sooner downshift after today’s announcement.
So when will a downshift occur? If the arguments for a downshift all hold true now, recognizing that Powell made many of them himself today, it seems that the only thing missing is some signal from the economic data that the Fed’s economic outlook is more or less on track. The economic data over the last few months has failed to provide such a signal, obviously, which is why the Fed delivered another outsized hike today. Going forward, however, we suspect the bar for the data to clear will be rather low. Even consensus-like prints would show a decelerating economy and a diminution in inflationary pressures. We expect that would be sufficient evidence for the Fed to downshift the pace of hikes at the December meeting.
Away from the discussion about downshifting the pace of hikes, the other theme in Powell’s press conference was the potential level of peak interest rates. While Powell was clear that this remains highly uncertain, he did say that “we still have some ways to go.” He also said that the Fed’s estimate of peak rates has increased since the last round of forecasts. These comments seemingly offset some of the tone from the conversation about downshifting the pace of hikes, and risk assets ended lower on the day. It should be emphasized, however, that discussions about peak rates are necessarily subject to more uncertainty. It’s not clear that Powell’s comments today really added much to that discussion; the outcome will depend entirely on the realized economic data over the next few months. In contrast, what is more certain after today’s meeting is that the Fed is preparing a downshift in the pace of hikes, and this now seems more likely than not at the upcoming December meeting.