The move to a broadly neutral stance and the circumstances the US economy faces are increasingly leading the FOMC to take a more balanced view of the risks regarding inflation and activity.
The July FOMC meeting saw a very important shift in the Committee’s communications regarding the future path of policy, with Chair Powell highlighting in the press conference that the Committee no longer feel behind the curve and can now assess the appropriateness of policy “meeting by meeting”.
In that regard, there was also a significant pivot in the opening sentence of the decision statement, with June’s “Overall economic activity appears to have picked up after edging down in the first quarter” replaced with “Recent indicators of spending and production have softened” in July.
However, this is not to say that the rate-hike cycle is complete or even that a pause is coming. Throughout the press conference, Chair Powell talked up the strength of the economy, despite a poor run of activity data, as well as the lingering upside risks for inflation. On interest rates specifically, he also made clear the Committee’s belief that policy needed to be “moderately restrictive” instead of broadly neutral as it is now at 2.375% – in the FOMC’s view.
To our mind, the most likely course for policy from here remains a 50bp increase at the September meeting – taking the fed funds rate to the upper end of the FOMC’s 2-3% neutral range – followed by two 25bp increases to 3.375% at December. But risks to this view look as though they are transitioning from being skewed to the upside to the downside.
It is obvious that inflation is currently far too high and, as yet, unclear whether the pulse is sustainably decelerating. However, Chair Powell was crystal clear in the press conference that policy acts with a lag, believing that “significant further tightening” is in the pipeline. Further, while the labour market continues to be assessed as strong, the singular reference in the Q&A to the stalling of household survey employment over the past three months makes apparent that the FOMC believe job creation has slowed materially and is at immediate risk. Regarding the outlook, we would add the additional concerns of rapidly decelerating hourly earnings growth; a household savings rate already back at pre-pandemic levels; and record-low University of Michigan consumer sentiment which argues for weak and delayed transmission of future income growth to spending.
Also notable in Chair Powell’s remarks is that, now that their stance is broadly neutral, risks related to inflation are no longer the Committee’s pre-eminent concern. Instead they are to be balanced with the building downside risks for activity and employment, resulting in a desire to undertake “just the right amount of tightening” to bring about below-trend growth and “not make a mistake” by creating the pre-conditions for recession.
For the policy outlook into year-end, it will therefore be as important to fully assess the labour market detail as the components of inflation. On employment, the pace of job creation in the establishment and household surveys; the pipeline of new openings from JOLTS; and any signs of accelerating redundancies via initial claims will all matter. For inflation, critical will be the degree to which inflation is within the FOMC’s influence or an uncontrollable force for policy, with the latter possibility better regarded as a tax on households’ real income and economic activity than an inflation risk the FOMC need to act against. Note, this more nuanced assessment of inflation risks will still need to be made in the context of developments in inflation expectations which the Committee assess through a number of measures.
As we have long emphasised, a continuous assessment of financial conditions is also necessary when calibrating policy. Term interest rates, at which economic agents borrow, have been heavy of late. If they track lower still, the FOMC will have scope to raise the fed funds rate further without a cost to the economy through market interest rates or the US dollar, all else equal. Alternatively, if quantitative tightening and the risks clouding the outlook see credit spreads widen, the FOMC will have less capacity to raise the fed funds rate, with some of the required tightening of financial conditions coming instead from market participants.
Regardless, given our inflation and growth forecasts, we believe the policy debate can turn to rate cuts in 2023. While somewhat more cautious than the market with respect to the timing of these cuts, by late-2023 we see the case for 125bps of cuts from December quarter 2023 to December quarter 2024 having been made as restoring growth back near trend by the close of 2024 becomes the FOMC’s key policy objective.
