The Fed: Higher rates for longer
Last Wednesday, the Fed decided to keep rates unchanged, maintaining the range at 5.25% -5.50%, in line with expectations, while also not presenting any new developments for reducing its holdings. In keeping with the decision, a new macro scenario of upward activity, deceleration of inflation and improved employment data was presented. However, the main focus, rather than updating forecasts, was on the rigidity of medium-term rates and the consideration of a neutral interest rate that is now estimated to be higher. With this narrative, the Fed is strengthening the main message of higher rates for longer, although with the first component it’s sketching out the first moderation biases in the sense of not necessarily much higher, with the second component, that of time, taking on the main role.
Based on the forecast table, the change in growth and employment data becomes positive enough to steer the line of activity toward a height above the landing, although unequivocally below the potential. So much so that part of the review proposed in 2023 runs through until fiscal year 2024. This strong review, while suggesting a clearer picture, also has a lower starting point (the 2023 forecast has been in the low range throughout the year without review) while continuing to imply a slowdown in the future.
At the same time, and unlike previous occasions where the greatest activity was accompanied by higher price pressures, inflation forecasts also joined the set of positive news, with forecasts that frame a slightly more promising slowdown, mainly in the reading of the general index. In this regard, it seems to be more of an update, incorporating the most recent data since the last meeting, than a new projection exercise, thereby availing of a certain respite in order to observe in more detail the price translucence of the most recent events (the salary demands being made by UAW), the rise in oil prices and new tensions regarding the spending path in the House of Representatives). All the foregoing, in common with Europe and other regions of the West, is contingent on a geopolitical scenario that continues to skew downside risks.
Consequently, this confluence of factors permeates the perspective of higher rates for longer, although the most important emphasis is on the time factor than on the suitability of the next 25 basis points. So much so that Jerome Powell opened up the possibility of considering a higher level of neutral rates than expected, which would mean maintaining positive real levels in the short and medium term until such time as a new point of equilibrium is reached. This conclusion is again evident in the expectation gap between the Federal Open Market Committee (FOMC) members and the market.
In general, the positivity that has materialized on the growth side over the course of the year is quantified, with a forecast that now includes the most recent dynamics, but whose narrative to shape the forecast may be excessively optimistic by eliminating the soft landing option from the range of scenarios. In the same vein, the dichotomy between activity and prices is more balanced on the inflation side, with a less intense response to upturns in activity, although far from being considered under control.
Despite this update, the short-term and medium-term baseline will continue to be marked by the ongoing slowdown of the economy and the accompaniment of lower price pressures, although subject to an environment of positive real rates as a reminder that the inflation outlook is still far from the 2% target and that its durability will focus on the new focus of attention.
At the same time, as a reminder of the pause under the command of Ben S. Bernanke (at levels similar to the current ones on September 20, 2007) and in the previous attempt to land the economysmoothly, the prolonged imposition of restrictive rates is tilted toward higher probabilities of ending up in a financial accident.
An uncertain terminal rate
Generally speaking, the 25 basis point hike was backed by a reduced consensus among the members of the ECB council, maintaining a balanced approach. This reinforces a cautious attitude towards further rate increases while not entirely ruling out the possibility of needing additional measures in the future. In tandem with this decision, a set of macroeconomic forecasts was presented, with the key message indicating a persistent stagflation scenario that is unlikely to resolve in the near term.
Since the last intervention, activity has continued to deteriorate. The Q2 quarter-on-quarter growth has been revised downward to 0.1% from 0.3%. Data on industrial production and retail sales declined again in July. Furthermore, the PMIs indicate that the symptoms of stagflation haven't abated; in fact, they have accelerated in August. This trend is evident not only in the manufacturing sector but also in the services sector, which is now showing initial signs of weakness.
Regarding inflation, the latest data from August do not paint a promising picture. The labor market and ongoing wage negotiations, which are being eroded by inflation in real terms, are eluding the expected slowdown. Efforts to moderate deficits and reinstate fiscal rules have not materialized. Moreover, the geopolitical landscape appears unfriendly, with Saudi Arabia and Russia manipulating oil supplies to artificially reduce output, leading to a continued rise in oil prices. This situation is exacerbated by the lack of agreement on Ukrainian grain.
On the whole, the ECB finds itself in a challenging position as it strives to strike a balance between concerns about a weakened economy and its commitment to price stability amid ongoing inflation risks. Although the interest rate decision did not receive unanimous support among council members and lacked broad market consensus, it represents a balanced approach that underscores the ECB's dedication to managing the current economic cycle. Looking forward, it sets the stage for maintaining interest rates within the current range, although not definitively, leaving open the possibility of further adjustments in the tightening cycle and delaying any consideration of lower interest rates.
So, the most likely scenario still points to the terminal interest rate having already been reached. The economy will continue its transition from inflation concerns to concerns related to the demand side. The ECB will retain its adjustment measures within its balance sheet tools as collateral effects become more evident, with this adjustment expected to unfold more seamlessly in the second half of the year, reflecting the cumulative impact of 450 bps.
Nevertheless, the risk scenario still suggests reasons not to dismiss the possibility of a 25 bps increase in December. This is underpinned by factors including the effects of a transmission mechanism that has not fully matured (with a lag of 6-12 months since the last rate hike), a slower economic deceleration than initially expected, particularly in terms of employment. Furthermore, inflation remains more persistent than desired by the ECB, continuing outside the target range throughout the projected period. This inflation trend is absorbing both internal pressures, such as wages and deficits, and external factors, including non-peaceful geopolitics.