Article originally posted to The Globe and Mail
The Federal Reserve raised its key interest rate by a quarter-point on Wednesday to the highest level in 16 years. But the Fed also signaled that it may now pause the streak of 10 rate hikes that have made borrowing for consumers and businesses steadily more expensive.
In the wake of the announcement, stock markets held to modest gains, but selling pressure emerged in the final hour of trading. Bond yields immediately slipped, with the US two-year – which is sensitive to Fed Reserve policy decisions – down by 9 basis points at 3.89% by late afternoon. Canada’s bond yield of the same tenure was lower, but more modestly. The U.S. dollar weakened immediately after the Fed policy decision, but quickly recovered.
Meanwhile, U.S. interest rate futures continued to price in a pause in Federal Reserve tightening at the June and July policy meetings, and they are pricing in 50 basis points of easing by this December
And interest rate move probabilities based on swaps trading in credit markets held steady for Canada as well. They continue to price in a 25 basis point cut in interest rates by the Bank of Canada by the end of this year.
Here’s how money markets are pricing in further moves in the Bank of Canada overnight rate for this year as of 320pm ET, according to Refinitiv Eikon data. The current Bank of Canada overnight rate is 4.5%. While the bank moves in quarter point increments, credit market implied rates fluctuate more fluidly and are constantly changing.
Here’s how economists are reacting:
Royce Mendes, Managing Director & Head of Macro Strategy at Desjardins Capital Markets
It’s clear from Jay Powell’s press conference that the Fed is very unclear about what comes next. After raising rates 25bps today, officials have yet to decide whether it’s time to pause. In fact, the Chairman unequivocally stated that no decision on a pause was made today. But, by removing the explicit forward guidance regarding the need for higher rates, policymakers certainly aren’t saying that higher rates are necessary either. The non-committal nature of the statement speaks to the degree of uncertainty about the evolution of inflation and financial system stress and also likely to disagreements among FOMC members.
Powell confirmed that officials simply don’t know whether rates are sufficiently restrictive. While the statement removed the part about needing to raise rates further to get them to be sufficiently restrictive, that’s not the Fed’s way of communicating that interest rates are now high enough to do the job. The Chairman said that it will be an ongoing assessment to determine whether or not further hikes are required and he wouldn’t even agree that the bar was higher to raising rates now. That said, Powell did imply that his rough estimate of the real policy rate is 2%, which is materially higher than most estimates of a neutral rate. So they’re clearly restrictive. But sufficiently so? That’s an open question.
If the committee is tilting one way or another, they’re keeping their cards close to their chest. Treasury yields are a few basis points lower following the press conference, but that’s hardly a definitive move. With the market not gleaning much information from the statement or press conference, individual Fed speakers and upcoming data have the ability to swing the odds in either direction. We tend to believe that upcoming data will support a pause in rate hikes beginning at the next meeting.
James Orlando, director and senior economist with TD Economics
Although the Fed’s statement keeps the door open to further hikes, markets think that the Fed is done. The knee-jerk reaction to the announcement was a drop in Treasury yields and a depreciation in the U.S. Dollar. Markets are looking for the Fed to remain on hold through the summer before starting to cut rates as early as September. … Although we too think the Fed is likely done with further rate hikes, we think September is too early for cuts. Given the lagged effects of the Fed’s past rate hikes and recent tightening in financial conditions, we think rate cuts are more likely to start at the very end of 2023 or early 2024.
Avery Shenfeld, chief economist with CIBC World Markets
As widely expected, the Fed opted to hike a further quarter point, but also avoided saying that they had reached a judgement that further hikes might be required. That wording was replaced by language saying that they would now monitor incoming information to decide whether more rate hikes are in fact needed, which suggests that they could be on hold for a while, as there will be need for some elapsed time before they would be able to make such a judgement, as long as the data aren’t overwhelmingly leaning towards stronger than expected growth and inflation. The change reflects new uncertainties over the banking system, which they describe as “sound”, while admitting that “tighter credit conditions”, which presumably would include both higher rates and recent banking developments, will weigh on growth and inflation, but to an uncertain degree. This is a hawkish pause, as the committee says it will be looking for signals on the need for additional firming, rather than a balanced statement that would have referenced potential moves in either direction. Similarly, they say they are “highly attentive” to inflation risks, with no similar statement on recession risks. But if, as we expect, Q2 sees little or no growth, and inflation signals continue to moderate, the May hike should prove to be the last for this cycle, with the first easing not likely until 2024, as we’ll also need time for inflation pressures to sufficiently abate. We’ll have a further analysis after the press conference.
Taylor Schleich, Warren Lovely & Jocelyn Paquet, economists with National Bank Financial
The headline decision had been pretty well telegraphed but it was really all about the guidance going forward as the end of the tightening cycle has come into focus. By discarding the line that “some additional policy firming may be appropriate”, it’s clear that a pause is the preferred policy prescription from here out. However, the FOMC still has retained some optionality on its key rate should economic/inflation developments warrant additional tightening. We would highlight that the dot plot from March’s meeting showed that a large minority of FOMC participants (7 of 18 members) preferred a higher year-end rate than this new target range (i.e., 5.0% to 5.25%). Thus, there remains a clear and distinct risk that we aren’t fully out of the woods on rate increases. However, owing to the incoming disinflation and economic weakness that we expect to see, we don’t believe that any further hikes will be needed/warranted. Now then, the focus is likely to continue shifting to the timeline for rate cuts and we’re sure Chair Powell will field some questions on this in the coming press conference. We do believe that lower rates could be in store by very late in the year, but we’d push back on market expectations for easing as soon as September.
Andrew Hunter, deputy chief US Economist, Capital Economics
Despite the renewed wave of concern over the health of regional banks, following the failure of First Republic, the statement language on the banking sector was little changed, with officials still believing that the economic impact of the turmoil “remains uncertain”. Alongside the direct impact of the 500bp increase in the fed funds rate over the past year, we continue to expect a tightening in credit conditions to drive a much sharper downturn in the economy than the Fed is allowing for. With labour market conditions already cooling, that should in turn help drive a more rapid decline in core inflation than officials expect. As a result, we still think the Fed’s next move will be an interest rate cut later this year, with rates eventually falling back more sharply than the markets are anticipating.
Sal Guatieri, senior economist, BMO Capital Markets
While the Fed isn’t slamming the door shut on another rate hike, the default position is to do nothing unless the economy and/or inflation surprise to the high side. The reaction in Treasury markets was muted, suggesting the FOMC pretty much nailed its policy communication.
Edward Moya, senior market analyst, The Americas, OANDA, a forex trading firm
The Fed’s tenth straight rate hike will likely be the last one in this cycle. The Fed is concerned that tighter credit conditions will weigh on economic activity and hiring, while helping maintain disinflation trends. Credit tightening is about to cripple the economy and it appears that as long as we don’t get a perfect storm of hotter-than-expected labor and inflation data, the Fed will keep rates on hold for at the very least till the end of the year.
The lag with shelter prices and weakening economic activity should assure inflation will fall below 4% before the end of summer, possibly making a run at the 3% handle. The Fed should be in a position to keep a lengthy hold until early next year.
With files from Reuters and The Associated Press
