While rates are likely to remain at peak to end-2023 to guard against inflation risks, this FOMC hiking is nearing an end.
At their January meeting, the FOMC returned to its customary pace of tightening following 2022’s extraordinary moves, increasing the fed funds rate by 25bps to a mid-point of 4.625%. Also as anticipated, the Committee held firm to their cautious approach with respect to inflation and financial conditions, making only marginal changes in the decision statement.
On the labour market, job gains continue to be characterised as “robust”. For activity, growth is assessed as “modest”. Together these views suggest the FOMC remains sanguine on the outlook, expecting a slowdown not a contraction or recession.
Two small but significant changes were made to the statement with respect to inflation and the policy outlook, however.
With annual CPI inflation having decelerated from 9%yr to close to 6%yr between June and December 2022, and we might add now with a six-month annualised pace of 2%, inflation was seen by the Committee as having “eased somewhat” while remaining “elevated”.
Interestingly, in the statement, no distinction was made between supply and demand factors or domestic versus global pressures. This could simply be because the Committee remains focused on total inflation, or it may be due to the inflation data from late-2022 signalling a staged but increasingly broad-based deceleration in inflation (more on this below).
The other change of significance is the focus now being on the “extent of future increases” rather than the “pace” of tightening at December. This small adjustment points to an end of the tightening cycle being near, although the continued use of the “Committee anticipates that ongoing increases in the target range will be appropriate” implies that the baseline peak fed funds expectation of the Committee remains 5.1%, as per their December meeting forecasts, 25bps higher than both the market’s and Westpac’s expectation.
Chair Powell’s remarks in Q&A were balanced overall, characterising the labour market as extremely tight while also recognising the material slowing in wage growth, this week confirmed by the December quarter Employment Cost Index. The discussion during Q&A regarding inflation inferred that the Committee believe the disinflation seen to date has been limited to goods; though the downtrend in market measures of rents is clearly pointing to an eventual easing in housing pressures.
On the other hand, Chair Powell remains concerned that services inflation (which he notes is 56% of core PCE) has not eased. While the FOMC’s mandate is headline PCE, services inflation will be the key signal for markets to watch. A slowdown in wage inflation is promising, but the risk is that services inflation, being impacted by a range of variables in addition to wages, holds up for longer than the market is expecting.
The Q&A discussion of the policy outlook was also finely balanced, with Chair Powell signalling the Committee has more to do, but also that financial conditions are now restrictive, with real interest rates positive across the curve. Further, the policy outlook was reportedly discussed in depth at this meeting. The Minutes will provide detail in due course, though note that updates to Committee forecasts will not be made until the March meeting.
Overall, we remain of the view that the FOMC is most likely to end this tightening cycle at the March meeting with one further 25bp hike before going on hold at 4.875% for the remainder of 2023. However, depending on developments in financial conditions and services inflation, they may feel a need to continue the current pace of tightening to the May meeting.
Regardless, the market is likely to remain focused on the timing and scale of the easing cycle to come, particularly with incoming data pointing to a stagnating economy with building downside risks for activity. To conclude, there was some encouragement for the market’s expectation that the easing cycle could come this year, with Chair Powell recognising that, if inflation fell significantly faster than the FOMC currently expect, the case for an earlier easing was credible.