Allegory of the Summer Barbecue: Analysis on the Stance of Fed Policy and the Likely Path Forward

Executive summary:

  • The FOMC raised interest rates by 25 bps today as expected, after skipping a hike at the June meeting.
  • The Fed continued to signal a "meeting-by-meeting" data-dependent approach to monetary policy. While the June Summary of Economic Projections suggested that there might be one more hike after today's, we think it's also possible that today's hike may be the last one.
  • We don't expect the Fed to start cutting rates until the labor market softens. If a recession materializes, we anticipate that the Fed would cut rates quite aggressively, perhaps even taking rates down to the zero lower bound.

The bottom line: We continue to expect a mild-to-moderate recession over a 12-18 month horizon. We believe it's prudent for investors to be disciplined, and we think that U.S. Treasuries can be an important defensive tool in portfolios.

Summer is here. Beaches are packed and the weather is hot. And the smell of charcoal fills the air as people flock to parks for summer barbecues. But getting the perfect piece of grilled chicken or steak is a daunting task. The U.S. Federal Reserve (Fed) faces a similarly herculean endeavor as it tries to bring inflation back down to its target.

Meat hasn't reached necessary internal temperature: Why the Fed raised rates after a June skip

After a piece of meat has been on the grill for a while, you might momentarily turn off the grill as you check the temperature with a meat thermometer. But as you poke the thermometer into the meat, you realize that it hasn't reached the required internal temperature to be fully cooked.

The Fed has made some noteworthy progress in its attempt to bring inflation back down to target. On a non-seasonally adjusted basis, core consumer price index (core CPI) inflation rates have fallen from a peak of around 6.6% year-over-year in 2022 to 4.8% year-over-year in June 2023. Core personal consumption expenditure (core PCE) inflation, the measure the Fed likes focusing on, has fallen from a recent peak of 5.4% year-over-year in early 2022 to 4.6% in May 2023, on a seasonally adjusted basis.

But core CPI and core PCE rates are still above the Fed's 2% inflation target. And with the unemployment rate continuing to remain near historic lows, and economic growth expanding at a 2.0% seasonally adjusted annualized rate in the first quarter of 2023, the Fed likely believed it needed to take additional action to ensure inflation rates would reach the desired level. Thus, the Federal Reserve decided to raise interest rates by 25 basis points (bps) today, even though it had skipped a hike in June. The meat was not fully cooked, so the Fed had to continue grilling.

Market reaction was relatively muted, with the S&P 500 ending the day roughly flat. Given that markets had placed a 99% probability on a 25-bps hike going into this meeting, the lack of a strong market response was understandable.