Market Strategist
Summary: With a second 75bps rate hike, Fed has now reached neutral rates, a level which signals that the central bank is neither stimulating the economy, nor cooling off. Lack of forward guidance has however turned the markets dovish. We believe inflation continues to face upside pressures, and that might mean another hawkish turn for the Fed in the current cycle is yet to be seen.
The Fed acknowledged that “recent indicators of spending and production have softened” while noting that job gains “have been robust” and that inflation “remains elevated.” This supports our view that even if a recession was to occur, it will remain mild. The state of the labor market is not consistent with an economy in recession. Meanwhile, inflation continues to be driven by energy crisis and tight labor markets, which means it has further room to run. There will be two more inflation prints before the next Fed meeting in September, and volatility of expectations of further Fed moves is likely to be higher.
Lack of forward guidance gave reasons for the markets to get a confirmation bias, and to think we have seen peak Fed hawkishness. We now have 50bps rate hike priced in for September, followed by two 25bps rate hikes in the rest of the year. For next year, markets are seeing 50bps of rate cuts, which brings the end-2023 interest rate about 100bps below the 3.8% that the June dot plot had hinted.
Powell refused to provide any clarity on the disconnect between market expectations and Fed’s June dot plot. The focus will now shift to the upcoming CPI releases and the update to the dot plot at the September meeting. With inflation remaining higher-for-longer, the peak rates rhetoric will expire just like the ‘transitory inflation’ rhetoric did in 2021. Financial conditions have eased since the June FOMC, and that is only likely to aggravate the inflation problem. That suggests that the Fed will have to take at least one more hawkish turn in the current cycle.
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