Inside Markets — Policy Decision

Markets wait on today’s Fed policy decision at 11am PT followed by Powell’s press conference  at 11:30. We expect the Fed will ‘skip’ a rate hike at this meeting with a hawkish statement and/or press conference as a counterweight to easing financial conditions that would follow a pause. We also expect the updated dot plot to include at least one more 25bp increase in the median 2023 dot. Market-based probability for a July rate hike is currently 57%, but there’s a growing sense the Fed is near the end of its hiking cycle as disinflationary data flows through.

Yesterday’s CPI print delivered a favorable outcome for risk assets after ‘core services ex-rent’ increased just +0.24% MoM. This is Powell’s so-called ‘super-core’ inflation measure that has basically returned to its pre-pandemic average of +0.23%. Within super-core, airfares and medical services were soft, while prices for lodging away from home came in higher. The YoY headline print was also favorable for risk assets at +4%, but we expect something in the low 3% range next month.  

Terminal rate expectations and YoY core CPI have been rapidly converging over the last four months.  A Fed funds rate that meets or exceeds YoY core CPI is considered to be sufficiently restrictive.  Yesterday’s report had core CPI at +5.2% YoY with a current terminal rate of 5.27% and a Fed funds rate of 5.25%. Skipping a rate hike at this meeting gives YoY core CPI an opportunity to fall below 5%, which makes next month’s CPI print more important than last month.  The Fed knows that core CPI should continue to decelerate in coming months as the shelter component begins to reflect high frequency rent data.

The Fed insists it will hold rates at an elevated level through year-end. But holding the funds’ rate at elevated levels with continued QT operations as inflation decelerates is aggressive monetary tightening. This is why bond markets have been expecting rate cuts starting in November.