As long as current trends persist, May’s hike is likely to prove the last in this cycle. We expect the first cut in December.
The outcome of the May FOMC meeting was broadly as anticipated, with the fed funds rate increased by 25bps to a mid-point of 5.125% and a conditional pause signalled.
Most notable was the change in the statement language regarding the outlook for monetary policy, with March’s “The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive” replaced by “In determining the extent to which additional policy firming 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”. The effect of quantitative tightening was also recognised, so too the uncertain scale of the contractionary effect of developments in the banking sector and associated regulatory reform.
These factors were also repeatedly highlighted by Chair Powell in the press conference, as was the fact that the fed funds rate is now at the level the March Committee consensus regarded as the peak for this cycle. While subjective and based off a central forecast of continued growth, from Chair Powell’s remarks, arguably the Committee believe the risk spectrum for the outlook is tilting to the downside.
As above, this is not to say the FOMC believe the economy is headed for recession, or that rate cuts will soon be required. Rather, they are sanguine on the outlook for both inflation and growth. Underlying their expectation is resilient employment demand, a tight labour market, and continued above-average gains for wages; combined, these factors look to be viewed as an offset to the drag on households from above-target inflation and contractionary financial conditions. At the same time, the FOMC is recognising that slack is beginning to build in the labour market and broader economy, with: wage growth coming down with inflation; activity data consistent with GDP growth well below trend; and businesses increasingly taking a defensive posture with respect to investment.
Regarding the baseline view for policy, the key question is how quickly US CPI inflation returns to target. From the March FOMC forecasts, it is clear that Committee members remain hesitant to declare victory on this front, with the low end of the central tendency range for 2023 3.0%yr (median 3.3%yr) and, in their view, inflation not back at target until end-2025. These expected outcomes argue for a long period of on-hold policy to fend off inflation risks. That said, the Committee’s view is predicated on continued growth in the economy in 2023 and a relatively quick return to trend growth through 2024 and 2025. Increasingly, the partial data for activity and the assumed consequences of developments in the banking sector stand against this view.
While our own forecasts for growth are broadly in line with the low-point of the Committee’s central tendency range from March, we view the risks as skewed to the downside, with the real prospect of recession. Our own take on the composition of inflation is also more constructive, with annual headline inflation seen at 2.5%yr end-2023 following a circa 2.0% annualised gain through the second half of 2023. Below-trend growth through 2024 (at least) suggests inflation pressures will remain modest over the remainder of the forecast period. It is our view therefore that the FOMC will be able to begin to cut rates in December 2023, and that the pace of easing will remain rapid through 2024, 50bps per quarter leaving the fed funds rate at 2.875% by year end. A low for the fed funds rate of 2.125% is seen by mid-2025.
Note the FOMC’s March forecasts point to a 3.1% fed funds rate at end-2025 and 2.5% in the medium-term, so our expectation is for a materially different policy outcome than the Committee’s. However, it is also worth emphasising that the market has already moved a long way towards our expectation, the US 10yr yield having fallen from a peak of 4.24% to 3.34% currently, we believe on its way to 2.50% in 2025.
In terms of the risks to the policy view, we must emphasise in conclusion that, while recent data has been constructive for our forecast of policy easing from the turn of the year, incoming data must prove the case. Services inflation has to undergo a significant deceleration, requiring shelter inflation to dissipate quickly. Employment growth and wage gains also must slow further. Although downside risks are more probable, as long as the labour market remains strong, their scale is likely to be limited. So the chance of an earlier or more aggressive rate cutting cycle than we have forecast seems slim at this stage.
