July’s 75 bps tightening is important, but overshadowed by PCE and earnings reports.
The Fed released its statement following their two-day meeting that concluded on Wednesday, and consistent with expectations they raised the Federal Funds rate target by 75 bps to 2.25-2.5%. The FOMC’s statement shows that there were no dissenting votes, which I would potentially expect to change as the choice between unemployment and inflation control becomes starker. It will be increasingly challenging for Chairman Powell to maintain consensus in the future given a weakening of the economy (e.g. Purchasing Managers Indexes). albeit with still very strong inflation.
There were few changes in statement from the June FOMC meeting, but a small indicator that there is some slowing of economic activity. The market believes that the Fed is “on the job” now, and this gets the Fed to what they believe is a neutral monetary stance. Nevertheless, while the Fed may believe they are no longer behind the curve in the struggle to contain price pressures, I don’t think they will pause their tightening activity in September. The Fed’s belief that it reached a neutral stance on rates may be as accurate as its forecast for inflation to be transitory.
Markets have already priced in interest rate cuts later in 2023, and that indicates an expectation of some level of “normalization” either due to recession or a soft landing. Inflation will likely slow, but not dramatically decelerate on a year-on-year measure (both basis and sticky inflation for shelter).
In sum, the Fed is adjusting to what has felt like a new environment vs. what we saw before the pandemic. However, inflation above 9% is a failure, and they should feel that they need to allow themselves to be much nimbler. The central bank appears to have finally ended the practice of providing forward guidance. In an era of uncertainty we don’t need any central bank locking themselves in to a bad policy move, especially when they are communicating that they are data dependent. Clearly the worst mistake the Fed has made in some time was made in the context of refusing to adapt quickly enough to changing circumstances.
The financial markets interpreted Chairman Powell’s press conference as dovish but has been wrong about that over the last several meetings. Just because he hinted that future rate hikes may not be as aggressive as the 75 bps seen in June and July doesn’t mean that much as it had been decades since a 75 bps tightening. Mr. Powell kept returning to the strength in the labor market as the rationale to hike rates aggressively. But labor market data is a lagging indicator and more forward indicators, such as the monthly PMI, are moving lower. If inflation turns down notably, we’re safe from further dramatic rises. But that’s been a tough trade thus far.
All that said, the Fed is the least interesting part of the last week of July. We also had the first print of second quarter GDP and the personal consumption expenditures price index, as well as company earnings reports for nearly half of the S&P by market cap.
Around GDP, the question was whether it would be negative or not. It was. But I suggest not paying too much attention to that. GDP is a lagging indicator and unless it is significantly negative (or positive) there will be numerous revisions and nuances. PCE is much more important, and all the dynamics of the CPI number are critical here. My opinion is that the nominal GDP numbers have been ok, it’s just that we’re splitting the amount apportioned to inflation and real growth in a more negative way than expected. This will likely continue.
Finally, earnings. Company guidance has been and will continue to be critical. While thus far we’ve seen misses, expectations were low and the belief that these more challenged earnings are transitory has been a balm for the market.