From the market’s perspective, this week’s Federal Reserve meeting wasn’t really about its intentions for September. Or for the rest of 2023. Or even for 2024, for that matter. What the central bank truly conveyed, and what has rattled markets, is an intent that regardless of whether it hikes another time this year or cuts a few times next year, the long-term rates trajectory is higher than what investors have had to live with in close to two decades. “Seeing these numbers in black and white clearly roiled capital markets,” Nicholas Colas, co-founder of DataTrek Research, wrote Wednesday following the Federal Open Market Committee meeting. For Fed Chair Jerome Powell, who spoke to the press after the two-day session ended, “Resetting market expectations about real rates was his most important mission,” Colas said. Rates matter to markets because they tie directly to the cost of capital. Since the depths of the 2008-09 financial crisis, money has been exceedingly cheap, and Wall Street, for the most part, has flourished. Companies have used low rates to finance growth, buy back stock and generally keep the liquidity taps open during a time of great expansion. But this week’s meeting indicated that Fed officials expect rates to stay higher for longer. One reason is that policymakers believe they need to make money more expensive to slow down the type of economic growth that has fueled inflation. Another is that they simply feel they can: Updated economic projections show that Fed officials expect unemployment to stay low and inflation to slowly fall back to their 2% target with little disturbance to economic growth. ‘Radical shift’ The latter position represents a “radical shift to a soft landing baseline,” said Krishna Guha, head of global policy and central bank strategy at Evercore ISI. One interesting point: The Summary of Economic Projections indicated unemployment rising from its current 3.8% to 4.1% over the following two years. That skirts the so-called Sahm Rule, named for Fed economist Claudia Sahm, which has shown that the economy goes into recession if the unemployment rate’s three-month average rises by 0.5 percentage point from its cycle low. The jobless rate outlook came as FOMC officials more than doubled their expectation for GDP growth this year, indicating that they can hold rates higher without causing a recession. From a market perspective, Guha thinks the “higher-for-much-longer rate path” will be good for cyclical stocks and the U.S. dollar, but present problems for the broader stock market and especially the technology stocks that have played such a big part in the 2023 rally. “We would be very worried if we thought the Fed would stick rigidly to its new high-for-much-longer priors,” Guha said in a note to clients. “Thankfully, we think Powell and Co will be pragmatic over time.” Doubts about hikes That reliance on the Fed not sticking to a set strategy and being data dependent is what is fueling some of the more dovish talk on Wall Street. Some Wall Street commentary Wednesday and Thursday focused on Powell’s professed adherence at the press conference to real rates, or the difference between the benchmark fed funds rate and inflation. The thinking there is that if inflation moves lower, the Fed won’t need to keep nominal rates as high because real rates will be rising. Morgan Stanley, for instance, stuck to its conviction that the Fed is done hiking for this cycle and in fact will start cutting as soon as March 2024., with three more reductions to follow. “The overwhelming reliance on growth from both the Fed and the market has created two issues. (1) is this growth picture sustainable, and will growth keep surprising to the upside? We think the answer is no, and no. (2) what happens if growth can exist without inflation pressures, as it has so far?” wrote Ellen Zentner, chief U.S. economist at Morgan Stanley. “Markets are vulnerable if growth upside surprises do not persist.” However, policymakers, in their dot plot of projections, indicated they now see only 50 basis points, or two quarter percentage point, cuts by the end of 2024. That’s down from four decreases as indicated in the last update in June. Less aggressive cutting is more in line with the thinking at Goldman Sachs, where economists aren’t looking for a rate reduction until the fourth quarter of next year. The thinking there is that the Fed will show a preference to hold rates higher, particularly if growth holds up while inflation comes down, a scenario the firm thinks is likely. “If FOMC participants move further toward our view that cuts are not necessary, they could conclude next year that if growth remains solid and the labor market remains tight, rate cuts are not worth the risk,” Goldman economist David Mericle said in a note. To be sure, Goldman doesn’t see any more hikes coming, either. Thought the dot plot did indicate one final increase this year, Mericle said that is likely just a way for the Fed to keep its options open should the data not cooperate with its goals. Uncertainty over where the Fed is headed will keep the market guessing. DataTrek’s Colas said central bank officials are likely to resist cutting until they see signs that the series of rate increases is having its “long and variable” lagged effect on the economy, or if some other type of “exogenous shock” comes along for the economy. “But, until one or both of those things happen, higher real rates are the Fed’s strategy to tame inflation,” Colas said. “This tells us that current equity market churn is unlikely to end until bond markets have settled out.”
