June FOMC: Talk is Cheap

The FOMC broadly matched market expectations at its June FOMC meeting by deciding to keep rates on hold at 5.00%-5.25%. This is the first pause in the cycle since the FOMC began lifting rates in March 2022. We were looking for the Fed to implement a final rate increase in the context of still strong core CPI/PCE inflation data and employment conditions that continued to surprise to the upside since the May FOMC meeting.

Despite the Fed's visible efforts to signal that additional rate increases are possible, we believe that the Fed likely ended its tightening cycle back in May. Indeed, while we can't fully rule out an additional rate increase before the end of the year, we expect the Fed to refrain from further rate hikes in 2023. We also maintain our forecast of a first rate cut at the December FOMC meeting as growth and inflation momentum slows.

Do Not as I Say, But as I Do

If the Fed really saw the need to send a strong hawkish signal to the market, the best way to communicate that message would have been through an actual rate hike. Indeed, Fed officials had ample margin to lift rates with a backdrop of core CPI inflation averaging 0.4% m/m since the May meeting and with payrolls averaging close to 300k over the last three months. We are of the view that the bar for additional rate increases will now be much higher after the Fed's decision to pause. In other words, the onus will be on the data to validate that more tightening is needed in order to bring inflation lower.

Furthermore, Chair Powell also made clear that "a decision hasn't been made" for July, and that the meeting will be "live". That is, the additional tightening projected through the 2023 dot plot (50bps more) could happen at any point this year if the data supports that decision.

According to our forecasts the data isn't likely to be there in the near horizon. We think the Fed will be hard-pressed to find sufficient reasons to hike over the next few months, particularly given the likely slowing in consumer prices over that period. Indeed, we are expecting core CPI inflation to average just 0.2% m/m over June-August — running at half the average pace registered over the prior three months. If our forecast is correct, the three-month annualized pace of core inflation will decelerate from 5.2% in May to 4.2% by the July meeting and to 2.3% by the September meeting.

Risks to our Fed Forecasts

We see two key risks to our expectation for the Fed to remain on-hold this year:

Labor Market: The steady pace of the labor market keeps wage growth from falling further and the unemployment rate remains close to record lows. If the Fed thinks that a precondition for guiding inflation sustainably in the direction of the 2% target is a softening labor market, then the Committee may tighten further. However, we find that difficult to support in the context of falling inflation. After all, the Fed still seems to be aiming for a soft landing, for which the recipe is falling inflation without the need for a sharp softening of labor market conditions.

Changing Goal Posts: The Fed may have pre-emptively decided to lift rates by at least another 25bp or 50bp this year regardless of the data. The reaction function has perhaps changed (once more) with the Fed moving from extreme data dependency to lifting the policy rate more gradually to a preconceived terminal rate that the Committee has aimed to achieve. However, we think that even if the Fed is trying to feel its way through the dark via more spaced-out rate increases, it will find that as long as easing inflation is consistent with a path toward the 2% target it will not need to raise rates further.