Katie Nixon, CFA, CPWA®, CIMA®
Chief Investment Officer, Northern Trust Wealth Management
There was no rest for central bankers this week as the Federal Reserve, Bank of Japan and Bank of England all met to review economic conditions and set monetary policy amid a global sense of uncertainty.
Are we reaching an inflation turning point?
The Federal Open Market Committee met this week, and while taking a pause from the rate-hike cycle is underway, the messaging was one of caution. The phrase “proceed carefully” was repeated several times by Fed Chair Jerome Powell during his press conference, and there was a sense of uncertainty — and perhaps a lack of forecasting confidence — among the FOMC.
To be sure, the post-pandemic landscape has rendered economists and strategists alike struggling to catch up to what has been remarkable resilience on the growth front and persistence on the inflation front. While some data suggests we may be at a turning point for inflation, with indicators pointing to a slowdown in core PCE — the Fed’s preferred inflation indicator — it is not clear that the Fed’s 2% target will be met soon, and there is a risk that inflation could reaccelerate. This set of potential circumstances is going to keep the Fed vigilant, and likely keep policy rates at a higher plateau for a longer period of time than history would suggest.
When is a soft landing not a soft landing?
The Fed released an updated set of economic projections this week, with upward revisions to the growth outlook. The Fed’s forecast for 2023 real GDP effectively doubled from the June forecast, to 2.1% from 1%. The 2024 forecast was also upgraded from 1.1% to 1.5%. There were commensurate improvements in the forecast for the jobs market, with unemployment now anticipated to land at 3.8% at year-end 2023 — which is where we are today — and only rise to 4.1% next year.
Despite the rosier outlook for growth, the inflation outlook barely budged, with the 2023 core PCE forecast falling to 3.7% in the latest report from 3.9% in the June Summary of Economic Projections, and remaining steady at 2.6% next year. Higher growth and lower inflation? Sounds like a soft-landing forecast; however, Fed Chair Powell was careful to communicate that the FOMC is not complacent around this outlook, and that the band of uncertainty remains wide. We continue to believe that the U.S. economy will avoid a recession, but our outlook for inflation keeps us cautious with respect to Fed policy and supports our view that we will likely have one more rate hike in this cycle.
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Is it time we reset expectations?
The FOMC revisions to the Summary of Economic Projections and the now infamous “dot plot” lifted the committee’s forecast for the 2024 fed funds rate to 5.1% from 4.6%, dimming the prospect for near-term rate cuts. Quite interestingly, there appears to be a growing debate at the FOMC related to the resting heart rate of fed funds over the long term. This “r*” is the rate at which policy is neither stimulative nor restrictive, and the rate appropriate to support the Fed’s dual mandate of inflation near 2% and full employment.
The expectation for this rate across the various members of the FOMC has been relatively tight with the upper band falling below 3%, yet the most recent projections show a wider band of projections, between 2.5% – 3.3%. This is important because many (most?) have been surprised at the resilience of the economy in the face of historically tight monetary policy, and that has led to a vigorous debate: Is the U.S. economy simply more immune to higher rates? Have structural changes to the economy led to a higher “resting heart rate” required to achieve policy objectives? This debate will continue, but we would caution drawing any conclusions just yet. We are still very much in the post-pandemic recovery period, where distortions abound and forecast error is high.
How are investors digesting the “higher for longer” forecast?
Market participants seem to be coming to peace, finally, with the “higher for longer” forecast, and U.S. Treasury yields rose markedly on the week. The U.S. 10-year Treasury yield continued its ascent, rising more than 10 basis points on the week and a full 26 basis points month-to-date, breaching the 4.50% level briefly — the highest level since October 2007.
The two-year Treasury yield also rose roughly 10 basis points over the week as well, staying above the 5% level hit earlier this month. The hawkish interpretation of the FOMC meeting takeaways was also reflected in weaker risk asset markets, with U.S. equities falling on the week and high-yield credit spreads rising by 10 basis points. Importantly, high-yield bond spreads have risen but remain quite well contained at below 400 basis points and are certainly not reflecting concern about the economic outlook.
How closely did global central banks' actions match the Fed's?
In other news: In a squeaker vote, the Bank of England voted 5 to 4 to keep rates unchanged at 5.25%, and agreed to accelerate the pace of quantitative tightening. This was a tough call, as inflationary pressure remains acute, but economic growth is clearly suffering under the weight of higher interest rates. Here is an explicit acknowledgement — similar to what we heard from the Fed this week — that we have yet to fully see the impact of the policy tightening that has already taken place, and that this increases the odds of overtightening, which should be avoided with a cautious approach. This was a tough call, however, and the BOE is facing a different kind of inflationary pressure that is very much driven through the wage channel.
There was some good news on the inflation front, with the August UK inflation report surprising on the downside with headline CPI slowing to 6.7% against a forecast that it would rise to 7%. While progress certainly has been made, 6.7% is unsustainably high. We anticipate that the BOE may be done hiking rates, but a “higher for longer” outlook is justified.
The Bank of Japan also met this week and left policy rates unchanged, which, while not a surprise to market participants, did cause the yen to weaken versus the U.S. dollar. The short-term policy rate was kept steady at -0.1%. The BOJ is facing quite a different issue from the rest of the developed world, and is striving to continue to stimulate the economy in order to get inflation sustainable and consistently to the 2% target. After decades of disinflation, and even as inflation trends well above target for well over a year, the Japanese central bank is taking a very cautious approach to policy tightening.