The two-day Federal Reserve policy meeting kicks off today and concludes on Wednesday with a press conference by Chairman Powell. Rising interest rates have been a big equity driver this year as the Fed tightens policy in the face of rising inflation. No surprise then that the proverbial eyes of the market are focused on the FOMC’s decision this week. Game on.
What should you expect?
Fixed income markets have priced in 75 basis points as their central case. The strong inflation print for June led to speculation that the Fed may up the ante again with a 100 bps hike. A spate of weaker data and a recent drop in inflation expectations took some pressure off, and Fed officials speaking publicly seemed to rally around the 75 bps hike (“It’s still huge”, said one of them.) This would take the rates to 2.25-2.50% range.
That, by Fed’s own assessment, is a neutral level of rates. Beyond that, policy gets restrictive. How far will they go?
What else should we watch for?
Press conference on Wednesday will be closely watched for clues. Powell & Co. use this pulpit to conduct “forward guidance.” It’s a way to talk up (or down) interest rates without actually adjusting the policy rate: all they need to do is signal what they EXPECT they’ll be doing at the next meetings and markets will do the work for them.
This is a clever - and effective - way to fine tune the level of interest rates without actually explicitly committing to that level. In contrast, Fed Funds rate can’t be adjusted up or down each meeting without a loss of credibility (“What are these guys doing??”).
Most likely, Chairman Powell will continue to drive home the message that inflation is unacceptably high and that the central bank is solely focused on getting it under control. Markets have already priced in another 100 bps of tightening in subsequent meetings.
The Dot Plot
Now for the famous Dot Plot. The Dot Plot is a chart that records each Fed official’s projection for the central bank’s key short-term interest rate. One dot for each official.
The expectations represent the official expectation where the Fed Funds rate will be at the end of each calendar year three years into the future. (For more on this, please read this much more detailed explanation.) The Dot Plot is not released at every meeting so it’s closely scrutinized when it does.
The last one is from June and it tells an interesting story.
Fed cuts coming?
As of June, the median projection for FOMC members was for the Funds rate at 3.4% by year-end. That’s very close to what the market is currently pricing in. However, for 2023 expectations start to diverge meaningfully.
The median Fed estimate for the end of 2023 was almost 3.8%, another 40 bps of hikes. The market begs to differ. It’s pricing in 70 basis points of rate cuts later in 2023.
What is the market missing? Or is the Fed’s crystal ball cloudy? The explanation may be more benign.
Markets are free to price in a scenario where higher rates cause a recession (and therefore required Fed easing). Fed members may not be: explicitly expecting that their policy is likely to push the economy over the edge is unlikely to go over well, inflation or not.
That doesn’t mean they don’t agree.
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