24 JUL, 2023
By RankiaPro Europe
On Tuesday and Wednesday, the Federal Reserve will meet to discuss economic issues. At this meeting, the US central bank is expected to raise interest rates by 25 basis points. This comes after at its last meeting in June, it decided to keep rates unchanged following a turnaround in the trend. Below, we present the forecasts that have been handled by international fund managers.
Inflation is receding and this is most evident in the US, where headline inflation fell to 3% in June. If the Fed raises rates again in July, implied real interest rates for next year will be well above those of the last decade. The market is therefore justified in expecting lower interest rates in 2024. This would imply an increase in the slope of the yield curve and positive bond yields. In this sense, US Treasuries are likely to outperform other major government bond asset classes. German and French government bonds have slightly outperformed US Treasuries (in the seven to ten-year maturity range). However, the ECB has more to do to reduce inflation.
It will be difficult for inflation to return to central banks’ targets. There is no sign that central banks will abandon their targets, so it may mean that they need to compress demand sufficiently to change the inflationary wage and price expectations that have built up over the past two years. This scenario is even more bullish for bonds, even if it means higher short-term rates. Inflation developments and central bank responses over the next six months will be very revealing as the nirvana of returning to long-established inflation targets approaches.
The forecast for the July meeting is for the Fed to raise interest rates by 25 basis points. This hike is virtually assumed by the markets and I doubt very much that the central bank will go against what the market already expects. I am doubtful that the Fed will raise rates further, as the decision will be highly data-dependent.
I do not expect too many surprises in the official statement. The latest labor indicator, as well as CPI, were weaker, but we are only a month in. At the press conference, I expect Powell to stick to the narrative about the importance of containing inflation and that the Fed needs to see more results to be sure that they are really winning the battle. Given that Powell will not want to ease financial conditions, which would be counterproductive to containing inflation, I think Powell cannot afford to sound dovish. That said, Powell sometimes goes off script and then you never know what the financial press and markets will latch on to.
Where the economy will eventually land remains a mystery. The path to a soft landing seems to have improved, both because of weak inflation and a slowing labor market. But much of the lagged monetary tightening remains to be seen. And even if the Fed ends its hiking cycle this week, the effects of the last 16 months of tightening could still push the US into recession.
With softer inflation, a final Fed hike is on the horizon. The latest inflation data are encouraging: they seem to suggest that price pressures are more moderate. Both total and core Consumer Price Index (CPI) inflation show more moderate increases, while producer and import prices point to weakening goods prices. The CPI inflation report contains other encouraging data: first, underlying price pressures are easing, with the core goods price sub-index contracting (-0.1%) on the month. Second, the most persistent part of inflation, services inflation, also declined, with an increase of only 0.3% on the month, the lowest reading since September 2021.
In addition, Powell’s super-core measure (i.e. services inflation excluding rental prices) stagnated, also registering the lowest reading since September 2021. Notably, rental prices continue to decelerate, in line with their downward trajectory, and confirm high-frequency data pointing to weakening prices in the rental market. Although the latest data are in line with a non-recessionary disinflationary path, we continue to expect a modest contraction in the last quarter of the year.
A 25 basis point hike at the next meeting in July seems very likely. While progress on disinflation looks “promising”, it seems that policymakers still want to see some more “good” data on inflation, as well as signs that labor market imbalances are diminishing. Only then would the Fed seem inclined to “wait and see, depend on the data, hike for longer”. Therefore, we also do not expect the Fed to change its clear hard-line stance at the next meeting.
Following his recent comments, and given his forecasts, the “preferred” tendency among US central bankers remains to err on the hawkish side rather than risk repeating the past mistakes of declaring victory too quickly. The great learning for the Fed of the 1970s remains that one should not give up at the first signs of moderating inflation. And since the disinflationary process so far has been driven in part by favorable base effects, the real work to bring inflation back to 2% may still lie ahead. We believe that a resolute focus on holding steady on inflation rigidity does not necessarily imply that the central banker should overshoot rates. Credible, hard-line guidance could help to effectively impose monetary tightness on the economy. This might be the best strategy, especially if the costs of getting it wrong are taken into account.
Thus, we could see the last rate hike of this cycle, but any moderate turn seems far away. This becomes important when it seems that markets might be a bit too optimistic with the recent “good” news on inflation. We would also like to highlight the fact that keeping rates stable while economic variables moderate always implies that monetary policy automatically tightens. Going forward, this should also ease pressure on the Fed to do more on the rate front in the remaining meetings this year.