BlackRock: Fed actions represent a 'hawkish skip'

15 juni 2023

Is it a pause? Is it a skip? Or is it data? Let’s dispense with the one-syllable answers and say that the Fed is seeking to balance increasingly restrictive policy with the time to see more data.

As was widely expected, the Federal Reserve today halted the most aggressive policy rate hiking cycle since 1980, leaving the Fed Funds range unchanged at 5.0% to 5.25%, a level that appears clear to us to be finally having an impact on the economy. We think the Fed actions represent a 'hawkish skip', which implies that policy makers are seeking more data before potentially hiking rates again in July, or September.

For our part, we think Chair Powell’s comments at the press conference made it clear that the FOMC is seeking to balance increasingly restrictive monetary policy with the high degree of uncertainty around the tightening of credit conditions, and a slowing (but still solid) U.S. economy, with a moderating (but still sticky) level of inflation.

In other words, the tightening effects from the regional banking stresses are still playing out, and there is high uncertainty around their effects on the economy, while economic conditions are normalizing on their own. Therefore, prudent risk management warrants holding at this time to allow for more information about how credit conditions are evolving. And if one word were to describe Fed policy from here, it is data. All the data, not just Core PCE (the Fed’s preferred measure), but on all the conditions present and influential on the central bank’s dual-mandate trajectory from here.

Changes to the Fed’s Summary of Economic Projections (SEP) today made it clear that the Fed has underestimated the resilience of the economy, the persistence of inflation, and that there are a substantial and increasing number of Committee members who envision the need for higher rates to tame inflation.

Indeed, the median estimate for the Fed Funds rate at the end of 2023 was raised by 0.50%, to 5.60% and the 2024 and 2025 year-end median projections were also increased modestly. This is not entirely surprising given that just yesterday Core CPI (excluding volatile food and energy components) printed at 0.44% month-over-month and 5.33% year-over-year.

Additionally, the Fed’s favored measure of inflation, Core PCE, increased 0.38% in April, bringing the year-over-year figure for the measure to 4.70%, as of that month, so while headline and goods sector inflation appear to be declining to more reasonable levels, core inflation and services sector price gains appear considerably stickier than many had anticipated.

Also, the fact remains that the labor market is still very tight. The unemployment rate is near a record low and the lowest wage earners are seeing their wages grow the fastest – trends that the Fed should look to preserve even as it seeks to quell inflation.

Labor market tightness is aided in part by a demographic trend that is difficult to reverse. Three million more Baby Boomers retired during the pandemic than would otherwise have been expected to, keeping labor supply tight. Meanwhile, several service sectors have yet to recover from the damage they sustained during the pandemic, creating robust demand for labor in those areas.

One potential avenue to boost the supply of labor would be if retirees came out of retirement and back into the labor force. However, since a retiree can earn 5% to 6% on their savings, without having to take much credit or duration risk today, this presents a hurdle for convincing many retirees to return. It was interesting to see the Fed drop its year-end unemployment target down to 4.10%.

We think this is the right adjustment to year-end projections, given these structural dynamics at play, and will clearly be one of the important data points that will drive the Fed’s disposition and policy adjustments from here.

This economic backdrop leaves the FOMC in the unenviable position of having to administer a single monetary policy to a resilient real economy that relies on a weaker financial economy for its funding. Unlike the market’s desire for simplicity, like one-syllable answers to describe complex monetary policy, we think the Fed’s process from here will consider the wide swathe of data, which influences the path to normalcy toward their dual mandate targets. Against that backdrop, interest rate cuts that were being priced in by the market over the next 6-9 months are looking increasingly improbable, barring an unforeseen catastrophe.

We expect that Fed policy makers will be deliberate in waiting for inflation and labor market data that helps them determine whether the momentum of inflation decline continues, whether the labor markets begin to weaken materially and observing the changes around the tightening of credit conditions.

If there is one term to describe what drives this and where their key philosophy is today, it is 'data'. The analysis of all the relevant data vs. one key inflation point. It will take longer to reach the Fed’s inflation long-term inflation target. The pace and momentum of all the economic data will determine when they need to do more tightening. Markets will study all this data intensively from here, keeping daily interest rate volatility higher than it historically has been, given how complex the mosaic of varied economic influences are and what results will be in the months to come.