Citing a lack of progress in reducing inflation, the Federal Reserve kept its policy rate unchanged at 5.5% at its meeting on Wednesday, the same rate it has had since July. The policy rate continues to be highly restrictive and will keep the economy cool in the coming quarters.
In the statement following its decision, the Fed also said it would reduce the pace of asset runoff by reducing the redemption cap on Treasuries to $25 billion a month from the current $60 billion starting in June.
Federal Reserve Chairman Jerome Powel emphasized that the slower pace of asset runoff does not work against the central bank’s restrictive monetary policy. Instead, he said, the slower pace of asset runoff, known as quantitative tightening, is intended to help the Fed manage its assets in a much more orderly fashion to avoid any market turbulence like the kind seen in 2019.
Both decisions were not surprising. But the statement by the Federal Open Market Committee and Powell’s news conference seem to strike a less hawkish tone than the market had expected. Powell cited strong economic growth, risks on both sides of the equation and why it is important to look at a longer time horizon than just the past three months.
We agree with Powell’s approach given that the cooling labor market, housing disinflation and somewhat stabilizing oil prices will most likely soon show up in the economic data, potentially pushing inflation down materially.
At the same time, we do not think the Fed needs to wait for all the data to come in to start cutting rates. After all, waiting too long to cut rates carries the risk of rising unemployment and weaker growth, which tend to worsen quickly once they take hold.
Powell acknowledged that rent disinflation is likely to show up, yet he was uncertain about the timing because of a lag in the data.
Read more of RSM’s insights on the economy and the middle market.
It’s this issue, of a lag in the data, that has proven so confounding to Fed officials and investors. In less than a year, the market and the Fed have had to make two significant recalibrations to interest rate trajectories based on fluctuations in short-term inflation data.
Their outlook brightened in January when inflation rapidly declined toward the Fed’s 2% target; at that time, four to five rate cuts were considered the baseline. But after three months of disappointing inflation data, markets had recalibrated their bets, and by the time of Wednesday’s meeting they were projecting fewer than two rate cuts this year.
These substantial shifts in sentiment have been the primary cause of the elevated volatility in financial markets in recent months. The Fed’s approach of being data-dependent—essentially backward-looking—has contributed to this issue.
The takeaway
There is no guarantee that another significant shift in rate path predictions won’t occur this summer. Factors like housing disinflation, a cooling labor market and stabilizing energy prices will materially reduce inflation, according to our estimates.
In our baseline, housing disinflation will come toward the end of the summer, which will most likely show up before the FOMC’s September meeting. For this reason, we see the first cut coming in September, followed by another in the last quarter if the economy remains on a solid trajectory.
