Economic Update - June 2023 - Fremont Bank

Market consensus leading into the Federal Open Market Committee (FOMC) meeting was for a pause, and that is what we got. The Fed voted unanimously to pause after its run of interest rate hikes, while sticking to its hawkish commentary. But was this the helping hand we wanted to see?

The Reasons to Pause:

In Fed Chair Powell’s Q&A, he reminded us that when they started on the hiking path it was about the pace, the trajectory, and the duration. They took into consideration how far and how fast they have moved, and policymakers judged it was “prudent” to hold rates. Adding that “we have moved closer to the sufficiently restrictive” area however, risks to inflation to the upside remain. He went out of his way to say that there was no clear discussion about the possibility of a July hike although “rates could move higher but at a slower pace.” Of course, they have always said they are data dependent. Therefore, this pause provides time to determine whether lagging data on economic activity and inflation may affect monetary policy going forward.

Surprise, Surprise, Surprise!

The Fed also released a better-than-expected Statement of Economic Projections (SEP). It is still seeing the economy continue to expand at a moderate pace, job gains are robust, and inflation remains elevated. The report indicated strong economic growth, with the economy forecasted to grow 1% this year, up from March’s 0.4% projection. Further, unemployment is expected to rise to 4.1% this year, well below the earlier 4.5% forecast. The SEP showed core inflation peaking at 3.9% this year, which is higher than earlier projections of 3.6%. The Fed’s favorite gauge of inflation is the Core PCE deflator, which was 4.6% last month on an annual basis after posting a high of 5.4% in February 2022. Powell mentioned that “although headline inflation has come down, they are not seeing a lot of progress with core inflation” and it continues to stay well above 4%. They need to see inflation come down “decisively” to pivot or change the trajectory of interest rates. Don’t forget: the Fed has stated in the past that 2% is the ideal rate of inflation.

Where the Dots Lie:

The revised dot plot--a chart showing participants’ estimates of what the federal funds rate should be given current market conditions--shifted upward, meaning higher expected interest rates. With the better-than-expected SEP, it is by no surprise that the fed funds rate is now set to peak at 5.6% this year, higher than the Fed’s previous March projections of 5.1%. More than half the participants supported two more hikes. Others supported either no more hikes or three more hikes; however, no participant believes a rate cut will occur this year. 

According to the graph below, the market- implied path of the fed funds rate and the change in the DOTS show the market is not buying into the Fed’s projections. The peak of the fed fund rate implied in the OIS market (Overnight Indexed Swap) is at 5.3% in September, suggesting only one increase is expected.

Looking Ahead:

So, was this the helping hand that we were all looking for? The Fed is now trying to control the speed of its rate hikes by skipping this meeting. It is plausible that this gives them another month of data to deliver a pivot. If you believe employment, housing, and manufacturing are slowing, then a pause would help. If you believe inflation is sticky and expectations stay elevated, maybe not. Either way, the job market data and inflation reports will be highly scrutinized over the next month.