FOMC Preview – Hawkish Pause

The Federal Reserve is widely anticipated to maintain its current policy rates during the upcoming Wednesday meeting at 2 PM. This decision is expected despite several positive economic indicators, including the addition of 336,000 new jobs in September, a 4.9% growth in real GDP for the third quarter, and core PCE inflation in September surpassing the target at 0.30%MoM. Instead of these economic factors, the primary reason for the Fed's decision to hold off on rate hikes is the rapid increase in ten-year Treasury yields, which reached approximately 5%. Chair Powell mentioned in a recent speech that the fundamental risk of inflation rising remains unchanged. Consequently, the language in the official statement and Chair Powell's comments are likely to maintain the possibility of future rate hikes. In my baseline scenario, I expect October's core CPI to show a 0.3%MoM increase, and the Fed will not implement a rate hike in December. However, if October's core CPI registers a 0.4%MoM increase, a 25-basis point rate hike in December becomes a more likely outcome.

The sudden surge in Treasury yields has made Fed officials more cautious about raising policy rates, increasing the likelihood that the Fed will refrain from further rate hikes during this cycle, which is now my baseline projection. Nevertheless, the persistent risk of inflation rising means that the committee cannot completely rule out the potential for future rate increases. While policy rates are currently on hold, the bias remains inclined toward hikes rather than cuts, aligning with the market's expectation of "higher for longer."

During the previous FOMC meeting in mid-September, the Summary of Economic Projections (SEP) indicated growing confidence among Fed officials that inflation would gradually return to the target without a recession, achieving a "soft landing." This optimism was driven by robust economic activity and job growth alongside a slowdown in wage growth and a three-month period of subdued core inflation from June to August. However, having previously overestimated the likelihood of a sustained decline in inflation over the past two years, Chair Powell and the committee were cautious not to declare victory in the fight against inflation or signal the end of rate hikes. In fact, twelve out of nineteen "dots" from Fed officials suggested that another 25-basis point rate hike would be necessary this year.

The Fed's decision to keep the door open for future rate hikes has proven to be prudent, considering the data released after the September meeting. Contrary to expectations of slowing down, job growth accelerated to 336,000 in September, partly due to seasonal adjustments, but the moving average remained above 200,000 per month, well above the natural growth rate in the labour force. Economic activity also picked up, with approximately 2% growth in the first half of the year followed by a robust 4.9% growth in the third quarter.

Of utmost significance for Fed policy, both core CPI and PCE inflation surged above 3% annualized in September. This clearly indicates that the earlier decline in core inflation rates to around 2% from June to August was a temporary "soft patch," primarily driven by decreases in airfare and used-auto prices, which are unlikely to persist. Non-shelter core services inflation, often referred to as the "super core," has remained resilient, increasing at a faster pace than pre-pandemic levels, and the super core continued to accelerate in the most recent September data.

Just a month ago, based on the data available, it was expected that the Fed would raise rates by 25 basis points at the November FOMC meeting, maintaining the every-other-meeting pace of rate hikes in line with their emphasized "data dependence." However, the rapid rise in ten-year Treasury yields to nearly 5% led Fed officials to adopt a more cautious approach toward further rate hikes.

Despite this newfound caution, I anticipate that Chair Powell will use the press conference to emphasize the Fed's commitment to data-driven decision-making and their readiness to respond if inflation risks materialize. Powell might clarify that the Fed is not targeting a specific level of ten-year yields but is more concerned about the speed and volatility of the yield sell-off. This implies that if yields stabilize, the possibility of further Fed rate hikes will remain on the table.

The crucial phrase in the post-meeting statement concerning rate hikes reads: "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." I expect this sentence to remain unchanged. A dovish surprise would be if the phrase "extent of additional policy firming that may be appropriate" is modified to "extent to which additional policy firming may be appropriate," removing the presumption that additional policy firming is likely to be necessary. Policymakers are likely to retain the language as-is, as changing it in a dovish direction could lead to the market pricing out the possibility of a rate hike in December.

Like his recent speech, Chair Powell (and the language in the post-meeting statement) will need to strike a balance between preventing further Treasury sell-offs while also maintaining stable financial conditions.

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