The Federal Reserve maintained its policy rate in a range between 5.25% to 5.5% at its November policy meeting on Wednesday.
Given the recent backup in Treasury yields, with the 10-year increasing by 124 basis points from 3.74% on July 19 to 4.98% on Oct. 19, the Fed intends to create policy space to ascertain the impact of higher financing costs while retaining a bias toward another hike.
But the market has priced in a low probability of the Fed’s hiking its rate in December and January at the next meetings of the Federal Open Market Committee.
We think that the Fed is done raising rates because of the tightening of financial conditions through the driving of yields higher over the past four months by investors.
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More important, rising yields and the return of a positive term premium—sitting at 0.43% just before the policy announcement—back to positive terrain have resulted in tightening financial conditions that are the equivalent of a 50 basis-point hike by the Fed.
Market dynamics, easing inflation and what we anticipate will be a moderation in hiring strongly imply that the policy rate is sufficiently restrictive.
The Federal Reserve is well positioned to sustain an extended pause to give the economy time to absorb those higher borrowing costs, which are already hindering investment growth, and to assess recent economic data.
In our estimation, double-digit borrowing rates to finance payrolls and business expansion will cause the economy to slow below the long-term growth rate of 1.8% over the next six months, down from the torrid 4.9% rate in the third quarter.
For this reason, we think that the Fed is and should be done with its rate hike cycle. In addition, with long-run real rates rising—up to 2.5% using 10-year Treasury Inflation-Protected Securities as the benchmark—the central bank will soon need to focus on stabilizing those real rates and then bring them down starting in the second quarter of next year.
Policy statement
The policy statement had limited changes but included updated language to account for this year’s strong expansion and moderating job gains.
More important, the Fed kept the language around inflation remaining elevated and the text that stated, “In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
That statement gives the Fed a bridge to a possible additional rate hike should inflation prove stubborn or accelerate.
Just as important, Federal Reserve Chairman Jerome Powell also reaffirmed that the central bank forecast does not include a recession.
While the Fed is in no hurry to hike rates further and is likely done, it has not yet declared a peak in the current hiking cycle.
Press conference
Powell reaffirmed the Fed’s bias toward an additional rate hike if necessary. Most notably, Powell stated that growth persistently above potential or continuing tightness in the labor market could warrant additional tightening of monetary policy.
By stating that he thinks policy is not yet sufficiently restrictive, the central bank wants to communicate its policy bias even as inflation continues to ease.
The takeaway
For now, the Fed is not planning on hiking rates in the near term even if it is not yet ready to declare a peak.
From our vantage point, the lagged impact of past rate hikes and the recent 124 basis-point increase in long-term yields caused by a stronger economy and risks around fiscal policy will most likely result in the end of the current cycle.
We do not anticipate rate hikes at either the December or January policy meetings. Policy is likely to remain restrictive for the next six months at least before the Fed considers a potential pivot in monetary policy.
