The Match Continues: The Fed vs. The Market

Chief Economist Eugenio J. Alemán discusses current economic conditions.

Wednesday’s Federal Reserve (Fed) decision to keep the federal funds rate unchanged wasn’t a surprise at all. Markets, as we argued last week, had predicted that the Fed was going to stay put and that is what it did. Coming out of the Federal Open Market Committee (FOMC) meeting, it kept another rate hike alive before the end of this year. It seems that markets are already second-guessing the Fed’s commitment as the betting markets are expecting, so far, that the Fed is going keep the pause for the rest of the year. If markets end up being correct, this will mean that 5.25%-5.50% is the end-of-cycle rate for this tightening cycle. The new dot plot shows that Fed officials are committed to keeping rates higher for longer, as they have been claiming for the last year or so. However, they now added some more ‘supporting evidence’ in the form of a better forecast for economic growth next year. But that was not everything, they supported their commitment to ‘higher for longer’ by eliminating two 25 basis points decreases next year compared to what the dot plot showed in June. This is a bold move, a move that will probably keep, once again, the markets second-guessing Fed members' intentions for, at least, the first half of next year.

The Fed’s implied explanation for this change is that it no longer sees a recession next year or, similarly, that it now seems to expect a ‘soft landing’ of the economy. Thus, the guidance it is trying to convey to the markets is that since it no longer sees a recession, markets should not expect interest rates to come down any time soon. Furthermore, if and when the Fed starts lowering interest rates, it will be at a ‘snails pace.’ This is probably the Fed’s way of saying that it wants interest rates to remain higher for longer. This one is, clearly, a tough pill to swallow for markets as they have become so used to expecting low interest rates.

Economic projections

In the graph above, we have plotted the federal funds rate and overall real investment at the top and then below we split real investment into real residential investment and real nonresidential investment. Also, recall that nonresidential investment is about two-thirds of total real investment spending while residential investment is the remaining one-third. The graph shows the strong negative effects of higher interest rates on real residential investment but almost no effects on nonresidential investment. Furthermore, as the graph clearly shows, today’s scenario is eerily similar to what happened back in 1994-1995 when the Fed engineered what some call a ‘soft landing.’

Perhaps the biggest question is what was happening to inflation at that time and what is happening to inflation today. In the 1994-1995 period, year-over-year the PCE price index as well as the PCE price index excluding food and energy were declining, i.e., disinflating, and very close to the 2.0% target. However, today, these two indices are also disinflating but are still very far away from the 2.0% Fed target (see graph below). Of course, if Fed officials believe that they have done enough to keep the disinflationary process going, then they may change their minds and not increase rates again. If this is the case, they may even be able to engineer another ‘soft landing’ as they did back in the mid-1990s. However, if Fed officials believe that the risks for inflation remain high, they may be willing to increase interest rates again. As it stands today, we still believe that the Fed is going to hike once more before the end of this year.

We will update our forecast for the federal funds rate once Fed officials release the Summary of Economic Projections, which will include the new ‘dot plot,’ after the September meeting of the Federal Open Market Committee meeting scheduled for September 19-20.