MNI POLICY: Fed Likely Done Hiking, Focused On Length Of Hold

The Federal Reserve is most likely done raising interest rates and policymakers are already pivoting to communication about the need for a prolonged period of higher rates, while expressing caution about whether inflation is sustainably headed to the central bank’s 2% target.

A confluence of dovish factors favor an extended Fed pause over any additional rises in the federal funds rate to a 22-year high of 5.25-5.5%. Fed officials are increasingly pleased by a consistent and broad-based recent decline in inflation, which has already pushed three-month annualized measures of PCE well below 3%.

Even annual inflation readings, which are hovering near the low threes, are on track to end 2023 below the Fed’s September forecasts for year-end PCE and core, of 3.3% and 3.7% respectively. U.S. central bank policymakers have openly discussed the need to reduce rates as inflation falls in order to keep the real rate of interest from rising and conditions from tightening.

At the same time, there is a strong emphasis on tighter financial conditions from higher long-term interest rates, even if those yields have retraced some of their spike. Some officials see this as further evidence of the long lags of monetary policy, with much of the impact still ongoing. (MNI POLICY: Fed Convinced Past Hikes' Full Effect Yet To Hit)

Policymakers are also heartened by a labor market that they believe is slowly coming into better balance without suddenly falling out of bed. On the demand side, officials point to slowing job growth, a lower quit rate and some moderation in wage gains as signs that tight monetary policy is having the desired effects. Rising labor force participation and immigration have been welcome surprises with regards to the supply of available workers.

The shift in messaging toward a focus on how long to keep rates at peak levels was evident in new language for the FOMC in the minutes to its November meeting: “All participants judged that it would be appropriate for policy to remain at a restrictive stance for some time until inflation is clearly moving down sustainably toward the Committee's objective.”

DOWNPLAYING RATE CUT HOPES

That’s not to say that officials are ready to declare mission accomplished on their inflation fight. To the contrary, having been burned before by what Fed Chair Jerome Powell referred to as “a few head fakes” in a Nov. 9 speech at the IMF, officials “know that ongoing progress toward our 2% goal is not assured.”

They are keeping an especially close eye on the path of wage inflation which, despite recent moderation, is still not at levels policymakers see as consistent with 2% inflation over time.

Yet the bar for further tightening of policy through further rate hikes has risen significantly. It would take a continued reacceleration of inflation, which most economists think might require an unexpected shock, for such an outcome to become plausible again. (See MNI INTERVIEW: Fed Hikes Over, Banks Still Vulnerable and MNI INTERVIEW: Fed Done Hiking, Eyes Long Hold-Ex-IMF Official)

And there’s not enough time for that to happen before well into the first quarter of 2024, by which time the committee might simply opt to reinforce its forward guidance on higher for longer rates if it feels the need to tighten financial conditions again.

Instead, while market participants have spent most of this hiking cycle prematurely obsessed with when rates would peak – and thus could turn their focus to the next move being a cut – this time, they are probably right.