I think that I’ve seen this movie before! Like part VII of a repetitive movie series (I’m looking at you Avengers), the Federal Reserve once again slapped down optimistic market expectations this week, signaling a ‘higher for longer’ interest rate policy, countering market hopes for lower interest rates in 2024. When we began 2023 there was widespread concern that a recession was imminent. However, as the year progressed those fears flipped as the economy showed continued growth. Despite progress on inflation, investors fretted that economic growth was too strong and inflation would come roaring back, spurred on by economic growth and low unemployment. With this backdrop, this week the Federal Reserve recommitted to keeping interest rates high to reign-in inflation. The market reacted by selling off. Overall, the S&P 500 is down 5.6% from its July 31 peak.
The Federal Reserve continues to stay on the path, but the risks of inflation have returned. So far, the Federal Reserve has been successful at reducing inflation while avoiding a recession. Since its 2022 high of 9.3%, Consumer Price Inflation fell to 3% in June before reversing course and ticking back up to 3.2% in July and 3.7% in August. Despite the progress, inflation remains far higher than the Federal Reserve’s target of 2% and is, at least these past two months, headed in the wrong direction. The uptick forced the Federal Reserve to issue a strong statement and commit to keeping interest rates higher for longer.
Faith is the Federal Reserve’s most important tool. The market must have faith that the Federal Reserve is committed to reducing inflation. If the Fed loses that confidence then interest rates, especially longer-term rates, could spike higher and cause even more significant damage to the economy. Notably, the 10-year bond yield, which the Federal Reserve does not control, rose to a 15 year high of 4.5% this week, signaling that the bond market is starting to doubt the Fed’s efforts.
The Federal Reserve kept the target range for the Fed funds rate at a 22-year high of 5.25%-5.5% in its September meeting following a 25bps hike in July. However, the Fed signaled that there could be another interest rate hike this year and that interest rates would remain higher in 2024 than previously anticipated. The Fed’s projections now show a Fed Funds rate of 5.1% in 2024 compared with a June forecast of 4.6% in 2024. This ‘higher for longer’ signal is intended to keep the pressure on inflation but also keeps pressure on economic growth and asset prices.
Once again, inflation is the story. It is important that the next inflation release, due in October, shows a reversal in downward movement once again.