Thursday, June 15, 2023
As expected, the Federal Open Market Committee (FOMC) kept rates unchanged at its meeting yesterday but communicated a hawkish bias to future interest rate decisions. With a slight tweak, the FOMC statement was modestly hawkish but still communicated to investors that the committee is data-dependent when “determining the extent of additional policy firming that may be appropriate.” (emphasis added.) They do not say more tightening “will” be appropriate.
Along with the statement, four times a year, the Committee updates it Summary of Economic Projections (SEP), which is arguably more important than the statement. Within the most recent SEP, most policy makers believe further tightening is needed unless conditions materially weaken. Additionally, forecasts for GDP growth this year were revised higher since growth in the first quarter was so strong. The economy could still slide into recession in the latter half of this year yet still approach 1% growth for the entire year. Our most likely scenarios put the economy in a mild recession by the end of the year as consumers retrench and businesses slow hiring as surveys suggest. Finally, unemployment is expected to rise from current levels but will not likely increase as much as Federal Reserve (Fed) officials originally forecasted. Importantly, the Fed recognizes the ongoing economic resiliency and it doesn’t expect things to get as bad as originally forecasted three months ago, which bodes well for the soft-landing scenario if the Fed is right.
However, the release of the dot plot, which is the individual Committee member’s expectation of the appropriate fed funds rate each year, was the hawkish surprise markets were worried about. Despite raising rates by 5% over the past 15 months, the majority of the committee, not just the median policymaker, sees at least two more 0.25% rate hikes this year, which would take the fed funds rate to 5.625%—the highest level since 2001. Moreover, the committee thinks the fed funds rate should end the year in 2024 at 4.625%, which reflects the potential for some rate cuts, but not as many as markets are expecting, which could put upward pressure on bond yields if the committee’s forecasts are accurate.
That said, and as we know from the great philosopher Yogi Berra, it’s tough to make predictions, especially about the future. And the Fed’s crystal ball is no better than the markets and we know from history that the dot plot is just not a good forecasting tool. As seen in the chart below, analysis by Bloomberg shows the median forecast rarely, if ever, coordinated with actual policy rates (dashed red line). Dot plot medians tended to overestimate policy rates—sometimes by a wide margin. The most egregious example appears to be in 2015 (green line) when the Committee expected interest rates in 2017 to be above 3.5%, when in actuality they were closer to 0.50% that year. Nonetheless, it is worth watching how these views evolve in the coming months, which means either the Fed lowers its forecasts or the market adjusts higher, putting upward pressure on bond yields.
Bottom Line: Periods of economic regime shifts are difficult for policy makers to manage. This current environment could be eerily similar to early 2007 when the Fed held a tightening bias on rates as they believed the housing market was stabilizing, the economy would continue to expand, and inflation risks remained. (See the historical statement from January 2007.) Clearly, those expectations were not met since we know what happened in later quarters. Despite the reference to 2007, our baseline is the economic slowdown does not produce another “2008” yet, investors should anticipate some volatility during these months where the economic outlook remains cloudy.
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