U.S. Fed hikes rates by 25 bps

The US Federal Open Market Committee (FOMC) decided to increase interest rates by a further 25 bps to a range of 4.5% to 4.75%. This was in line with market expectations. The Federal Funds target interest rate has increased by a total of 450 bps since the beginning of 2022. US inflation was last measured at 6.5% y/y in December 2022 (core inflation 5.7%) and is clearly trending lower, while the labour market remains strong with the unemployment rate at 3.5% and job openings rising back above 11 million openings. While it seems clear that some parts of the US economy are slowing – including the housing market and housing activity as well as private sector fixed investment and industrial activity – activity data in some parts of the service sectors remains relatively firm.

Within the FOMC statement, the Fed stressed that “recent indicators point to modest growth in spending and production. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation has eased somewhat but remains elevated.” Furthermore, the statement highlighted that “the Committee anticipates that ongoing increases in the target range will be appropriate.” In other words, you cannot easily assume that the Fed will hike rates only once more this year by 25 bps, despite the fact that the Fed has been willing to scale back the pace of rate hikes.

There was no update to the FOMC ‘dot-plot’ at this FOMC meeting. The next SEP will be updated in March 2023. The previous “dot-plot” indicated that the Fed will likely increase interest rates up to a range of somewhere between 5% and 5.5%. The dot-plot also indicated that the Fed would start to cut interest rates in 2024. While the dot-plot spread appeared sensible for 2023, the divergence in interest rate expectations for 2024 and 2025 is startling.  

In the press conference following the FOMC decision, Chairman Powell highlighted that the FOMC “needs more evidence that inflation is on a sustained downward path”. In addition, Powell repeated his view that the risk of increasing interest rates too little is greater (worse) than the risk of increasing interest rates too much. Powell has previously indicated that the Fed needs to keep rates elevated (restrictive) for a significant period to get inflation under control, especially core services inflation (excluding housing). He has also indicated that interest rates would only be cut when the FOMC is convinced that inflation is slowing on a sustained basis, but not necessarily only when inflation is back down at around 2%. All of this would suggest that at least another one or two hikes of 25 bps should be expected (Powell suggested a “couple of rates hikes” are needed). Interest rates will only start to be cut in 2024.

Overall, the Federal Reserve has made substantial progress in restoring its inflation-fighting credentials, mainly through an acceleration (front-loading) of interest rate hikes. In hiking rates further (albeit at a slower pace), and signalling that rates are likely to increase a little further during the first half of 2023, the Fed is signalling its commitment to getting inflation back down to 2% and appears unlikely to ‘settle’ for a higher inflation outcome.