Unraveling the recent Fed decision

June 15, 2023

The recent decision by the Federal Reserve to maintain the current interest rate level was largely anticipated, though it raised eyebrows in some respects. While many predicted a pause in rate hikes, there were underlying factors that influenced the Fed's cautious approach. In this blog post, we will explore the reasons behind the pause, analyze the signals of inflation that have guided the Fed's decision-making, and discuss the immediate future and potential implications.

The pause: a result of prior guidance and global precedents

It comes as no surprise that the Fed chose to pause its rate hikes, as the implied probability of holding rates steady stood at around 70% a week ago. However, a less-discussed lesson comes from the experience of Australia and Canada. Both countries attempted to end their own hiking cycles earlier this year but were compelled to raise rates again due to persistent inflation. This example likely made the Fed cautious, favoring a "skip" instead of a mere "pause."

The inflation conundrum: insights and indicators

Inflation concerns have been at the forefront of the Fed's considerations. Although overall inflation is on a downward trend, core inflation is decreasing at a slower rate than expected. In fact, annualized core inflation has recently shown month-over-month increases, indicating a less favorable environment for anything other than further rate hikes. The Fed's own projections for year-end core inflation have also been revised upward, adding to the case for continued vigilance.

Analyzing shelter inflation and current data

A significant driver of the inflation index is shelter inflation, which accounts for about a third of the overall index. However, it is important to note that shelter inflation is a lagging indicator as it reflects an average of existing leases. To gain a more accurate understanding of the current inflation situation, it is necessary to examine more up-to-date data sources, such as Zillow's rent index, which is based on new monthly leases. This data reveals a moderation in inflation, which will factor into expectations.

Immediate future: dot plots and guidance

The recent Fed dot plot indicates that the overall committee expects two more 25-basis-point rate hikes this year. This revelation caught many by surprise, as did Chairman Powell's statement that the next meeting would be a "live" one. This unconventional choice of words is a strong indication that the late July meeting will likely introduce another rate hike. Similarly, money markets are currently anticipating one additional raise in late July, with an implied probability of such a raise sitting at 70% or higher.

Examining the press conference and market reactions

The press conference following the Fed's decision raised several eyebrows. Investors questioned why the committee had seemingly boxed itself in with prior messages of a pause when the data received in the preceding weeks could have justified a hike, as reflected by the upward movement in the dot plot. Moreover, monetary policy is often said to “operate with a lag”, so the idea that another month of time would make the future path obvious was rightfully met with skepticism, notwithstanding the fact that more data points will have landed during that time. These factors likely contributed to the market's surprise, though price impact was largely negligible.

The Fed's decision to maintain interest rates reflects a delicate balancing act between inflation concerns, prior guidance, and global precedents. While inflation signals have been mixed, the Fed remains cautious in its approach, attempting to avoid either overheating on the upside or a recession on the downside. The immediate future suggests further rate hikes starting with the late July meeting. Despite criticism surrounding the press conference, the Fed's decisions and comments were likely influenced by a desire to avoid market turbulence resulting from a surprise decision.

As the year unfolds, we expect the Fed will be paying attention to personal consumption expenditure, credit standards, demand for loans, and inflation, particularly for shelter. Market participants, meanwhile, are continuing to closely watch the commercial real estate sector for early signs of trouble.

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