Fed to keep rates elevated for longer

September 25, 2023 23:03
Federal Reserve. Reuters

The FOMC kept the Fed funds target range at 5.25-5.50%, as widely accepted, maintained the tightening bias in its statement, and left the median dot for 2023 unchanged at 5.6% in its revised Summary of Economic Projections (SEP), suggesting that it’s ready to raise the policy rate by another 25bp before the end of the year, as we had expected.

What came as a surprise were the revised projections for 2024 and 2025, which suggest that the FOMC will maintain a more restrictive stance than indicated in its June SEP in the face of a significantly more optimistic economic outlook. FOMC officials now expect to cut rates more gradually than previously indicated, with the Fed funds rate ending 2024 and 2025 50bp higher than previously indicated, and policy remaining restrictive through 2026.

This year’s economic growth has been revised sharply upwards to 2.1%, which wasn’t surprising given the stronger-than-expected GDP projections so far this year. But the new projections also show that growth will remain resilient in 2024, ending the year at 1.5%, just below the official estimate of the economy’s potential growth rate of 1.8%. The unemployment rate is now expected to peak next year at 4.1% instead of 4.5%, also slightly above the longer-term projection of 4%. Inflation is still expected to gradually decline to 2% in 2026.

At first glance, it appears that the Fed is doubling down on its soft-landing view and that it now believes in ‘immaculate disinflation’, where there is essentially minimal pain involved in bringing inflation back to target. To us, these numbers are more about posturing than forecasting. When Chair Powell was asked if the soft-landing scenario had become the Committee’s base case, he replied that it hadn’t and that the new projections were rather an extrapolation of what had happened since the beginning of the year.

The important takeaway for investors is that if the economy remains more resilient, perhaps because the short-term neutral rate has moved higher, the Fed will keep rates higher for longer in order to get the job done. Mr. Powell reiterated that the worst mistake the Fed could make would be to declare an early victory over inflation, as it did in the 1970s, taking its foot off the brake too soon and ultimately failing to restore price stability. This time, the market has taken him seriously and priced out some of the cuts for next year. The likely outcome, therefore, is that rates will remain elevated until weaker economic data create enough slack in the economy to reduce inflationary pressure in a sustainable way.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin