The Fed: More hawkish than before, less hawkish than feared

• While the Fed left rates unchanged at its meeting on 1st May, there were some notable changes to the statement accompanying the meeting. The statement noted that labour markets remain tight, economic activity is expanding at a solid pace and “the lack of progress” on inflation moving towards target.
• The statement reiterated the point that the Fed does not expect to ease policy until it is more confident “that inflation is moving sustainably toward 2 percent”.
• Separately, the statement said the Fed will reduce the rate at which it is shrinking its balance sheet. Specifically, the cap on the monthly reduction in the value of US Treasuries on its balance sheet will be cut from $60bn to $25bn. However, the redemption policy on agency and mortgage-backed security (MBS) debt will remain unchanged for the time being at $35bn per month. 
• As ever, the statement reiterated that the Fed remains sensitive to incoming data and will react accordingly.
• In the press conference after the meeting, Powell was asked several times about the possibility of hiking rates. This was something he pushed back against, noting that the labour market is in better balance, progress on inflation is expected to resume later this year and that the Federal Open Market Committee (FOMC) believes policy is already restrictive. 

Chart 1. Expected number of Fed rate cuts in 2024

Source: Bloomberg. Data as at 2 May 2024.

• US Treasuries rallied following the announcement. The equity market reaction was muted. 
• In interpreting the statement and press conference in the context of recent macro releases, it is clear that the future path of Fed policy has become more uncertain. Futures are now pricing only slightly more than one rate cut this year. 
• It is interesting to note that although Powell dismissed the idea of another rate hike as unlikely, the topic was not even being discussed until relatively recently. While it is not the central view, our interpretation is that there is therefore an increased – if relatively low - probability that the Fed hikes again. This would happen if, for example, the labour market remains tight while inflation metrics remain stubbornly above target. 
• That also brings with it the possibility that the Fed makes a mistake: that it misjudges the leads and lags between policy changes and the economy, potentially causing an economic slowdown by retaining policy that is too tight. That may then precipitate rate cuts in say 6-12 months’ time. 
• Whereas for many years the Fed did not need to worry about inflation – which was structurally low around the world – and so could concentrate on the full employment dimension of its mandate, that situation has now reversed. Labour markets have remained tight despite the dramatic policy tightening that took place in 2022 and 2023. Instead, the Fed’s policy decisions are now dominated by inflation, both actual data and the outlook.

Chart 2. Different measures of personal consumption expenditures (PCE) inflation – 6-month annualised

Source: Bureau of Economic analysis, EFG calculations. Data as at end March 2024.

• The key then for ascertaining when and if the Fed will change policy rests mostly at the moment on the inflation data. Keeping a close eye on the underlying inflation dynamics is therefore of utmost importance. We note that the inflation situation has worsened recently, with some of the key 6-month annualised measures increasing over the past few months. 
• The fed funds rate represents an anchor for the yield curve. In terms of market impact, the expected terminal fed funds rate and the speed with which it gets there are therefore highly relevant for the treasury market. The higher the terminal rate and the longer it takes to reach it, the greater will the upward pressure be on US treasuries and the curve. (See our Infocus “Thinking about yields and yield curves” from 29-Sep-23 for more detail on this. www.efginternational.com/doc/jcr:83a07fc5-021e-49eb-a4bd-d43b3e87a049/Infocus_thinking_about_yield.pdf)