February FOMC Meeting

As expected, the FOMC yesterday agreed to hike rates by 0.25%. This represents a slowdown relative to the pace of rate increases implemented through most of 2022. Accompanying the decision to hike rates was a sentence confirming the Fed’s intention to continue to shrink its balance sheet. All 12 FOMC members voted for the hike and for continued balance sheet shrinkage.¹

This meeting did not include an updated Summary of Economic Projections (SEP) so there was no window on the Fed’s thinking with regards to the economy and the outlook for the fed funds rate. Instead, investors had to rely on the press conference hosted by FOMC Chair Powell to glean information. In that press conference, Powell adopted a hawkish tone, reiterating the need to keep policy tight until the data supports the view that inflation is fully under control. Powell stressed that he expects the fed funds rate to move higher and for the policy stance to remain restrictive “for some time”.

FOMC members, including Chair Powell, are incentivised to continue to talk tough even though there is a large gap between market expectations and the Fed’s own projections for the path of the fed funds rate, as encapsulated in the so-called Dot Plot (Chart 1). Whereas futures markets are pricing in a peak in the fed funds rate at under 5%, the most recent Dot Plot from December indicates that the median FOMC member thinks the fed funds rate will peak at a little over 5%. Moreover, the median FOMC member thinks the fed funds rate will remain unchanged throughout the year once its peak is reached whilst futures markets are pricing in cuts in the second half of the year.

Chart 1. Dot Plot versus Fed Funds futures

Source: Federal Reserve, Bloomberg, EFG calculations. Data as of 02 February 2023.

Even if Chair Powell and other members of the FOMC privately have sympathy with the opinion expressed in futures markets – and there is no evidence that they do – there is an asymmetric payoff in making those views public. If the Fed adopts a less hawkish tone in its communications there is a risk financial market conditions loosen, providing a stimulus to the economy and offsetting the policy tightening at the short end of the curve. If the Fed relays a consistently hawkish message to markets that reinforces the view rates will stay higher for longer, the risk of market monetary conditions loosening is diminished. If the Fed subsequently needs to cut rates, for example because there is a significant slowdown in economic activity or inflation suddenly collapses, they can easily change their mind and justify earlier-than-expected stimulus. As long as they do this in a manner that is consistent with the data, their credibility will remain intact. In other words, the Fed can afford to overtighten and then cut if required to do so, for example if a recession ensues.

For the time being it is therefore rational to expect the Fed to continue to talk tough even if this differs from market expectations. With headline PCE inflation still at 5.0% and the 10-year Treasury yield at around 3.5% real interest rates are very low.² Furthermore, the US labour market remains surprisingly tight. Until there is greater evidence that both inflation has slowed further towards target and the jobs market is suffering the Fed is unlikely to change tack. However, that may happen at a point in time sooner than indicated by the most recent Dot Plot.

¹The FOMC also reaffirmed its “Statement on Longer-Run Goals and Monetary Policy Strategy”.
²Although interest rates on TIPS are in positive territory.