The U.S. Federal Open Market Committee (FOMC) raised its key policy rate by three-quarters of a percentage on September 21st to battle higher inflation. In its fifth interest rate hike since the start of the COVID pandemic, the Federal Reserve (the Fed) increased the Federal Funds Target rate to an upper bound of 3.25%. Short-term yields surged on the news, with the key 2-year Treasury yield rising by 10.5 basis points to just over 4%. The 10-year yield remained relatively flat, while the 30-year yield declined by 4 basis points to 3.5%.
In a sign of how quickly the inflation picture has shifted in the U.S., the current yearend target of the Fed Funds Rate of 4.4% is up 2.5 percentage points from the 1.9% projection from the central bank in March. Furthermore, the FOMC also updated its near-term forecast of interest rates in its “Dot Plot” report. That report now indicates that the FOMC may very well raise rates by a further 75 basis points in its next meeting, making this one of the steepest federal reserve tightening cycles in modern history.
Chair Jerome Powell said during the press conference following the decision to hike rates that it would likely take more time for the financial conditions to tighten by the Fed’s plan. Financial conditions usually take longer to tighten and function at a lag. This transmission of policy into the real-world economy historically takes anywhere from three months to a year to happen.
The Chair also indicated that while he believes another large rate hike in the FOMC’s next meeting in November may be appropriate, the FOMC’s ultimate course of action would be data deterministic. That language is a slight change from the June meeting when the Chair broadcasted that there would be a large hike in July regardless of the incoming data. In the past few months, as inflation has heated up, explicit guidance on the size of the next move has become more common.
Powell also said that the battle against inflation would mean continued rate hikes from the central bank. Price pressures remain elevated across a broad range of products and services. Third, and probably most importantly from a markets perspective, when asked if market expectations for rate cuts in 2023 were realistic, the Chairman only said that it was too early to look so far ahead. Investors, who have come to expect sharply hawkish commentary from the Chairman lately, may have been surprised by the openness to the idea that a slowdown induced by rate hikes in 2022, may necessitate rate cuts as early as 2023.
The Fed also does not believe that the U.S. economy is currently in a recession but did point out that the path towards avoiding a recession while simultaneously tackling inflation was becoming narrower. Monetary policy is anchored in the theory that early increases in interest rates are critical to controlling inflation and inflation expectations, and delaying hikes make it harder to deal with the problem. The Chairman also noted that the Fed is keen to see the economy grow slower than it would otherwise to give supply chains time to recover. Historically, a slowing economy and a weaker job market are required in tandem to slow down the rate of inflation.
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