As expected, the Federal Reserve left its key policy rate—the federal funds rate—unchanged in September at a range of 5.25% to 5.5% but signaled that another rate hike later this year is the consensus view. The overriding message from the Fed is that it will continue to keep rates high until inflation comes down. This "higher-for-longer" message reflects a high level of uncertainty at the Fed about what it will take to move inflation sustainably lower.
At 5.5%, the upper bound of the federal funds rate is the highest since 2001
Source: Bloomberg.
Federal Funds Target Rate - Upper Bound (FDTR Index). Data as of 9/20/2023.
Statement changes
The Federal Open Market Committee (FOMC) made a few modifications to its statement. It noted that economic growth was expanding at a solid pace, an upgrade from the previous statement that said activity was expanding at a "moderate" pace. It changed its description of the labor market, highlighting that job gains have slowed, as opposed to the "robust" job gains noted in June. In describing inflation, the Fed said inflation remained elevated, which should be no surprise considering that most inflation readings remain well above the Fed’s target.
Are we there yet?
The big question facing the markets is: Are we at the peak in the federal funds rate for the cycle, or are there more rate hikes ahead?
Based on the "dot plot," which summarizes projections of Fed members about where the policy rate is going, the consensus still looks for one more rate hike this year, and the size of rate cuts in 2024 diminished somewhat. The dot plot is a chart that records each Fed official's projection for where the federal funds rate will be at the end of each year, as you can see in the chart below.
The median dot for next year suggests a year-end rate of 5.1%, compared to a median projection of 4.6% at the June meeting—a 50-basis-point difference. Likewise, the year-end fed funds rate projection for 2025 was revised up to 3.9% from 3.4%. In other words, Fed projections suggest a "higher-for-longer" interest rate environment.
The longer-run projection was unchanged at 2.5%.
The FOMC's dot plot suggests rates may be higher for longer
Source: Bloomberg.
FOMC Dot Plot as of 9/20/2023.
The Summary of Economic Projections (SEP) indicated that the Fed is looking for gross domestic product (GDP) growth and inflation to slow over the next year. Although the 2023 and 2024 GDP projections were revised higher from June, the committee is projecting growth to slow from 2.1% this year to 1.5% next year. The unemployment rate projections were also revised higher.
The Summary of Economic Projections anticipates slower GDP and inflation growth
Source: Federal Reserve Board, 9/20/2023.
Notes: For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections. The central tendency excludes the three highest and three lowest projections for each variable in each year. The range for a variable in a given year includes all participants' projections, from lowest to highest, for that variable in that year. Longer run projections for Core PCE are not collected.
Based on Fed Chair Jerome Powell's comments after this meeting, the Fed doesn't appear confident about reaching its goal of 2% inflation in the near term, but does believe policy is currently "restrictive," or tight enough to slow growth and inflation. He was referring to the high level of real yields—adjusted for inflation—which have reached levels not seen since 2008. High real yields tend to dampen consumer spending and business investment.
Real yields are at the highest levels in years
Source: Bloomberg, daily data as of 9/20/2023.
US Generic Govt TII 2 Yr (USGGT02Y INDEX), US Generic Govt TII 5 Yr (USGGT5Y Index), US Generic Govt TII 10 Yr (USGGT10Y Index), US Generic Govt TII 30 Yr (USGGT30Y Index). A basis point is one hundredth of 1 percentage point, or 0.01%. Past performance is no guarantee of future results.
What's next?
It's worth noting that even if the Fed is done with its rate hikes, monetary policy is still "tight." Leaving short-term nominal rates at current levels as inflation falls will send real yields—adjusted for inflation—higher. In addition, the Fed is still in the process of reducing its balance sheet by allowing bonds it holds to mature without replacement. The Fed has signaled that process is likely to continue even when it shifts to lowering the fed funds rate. Watching to see how all of these policy measures play out will likely keep the Fed on hold until Q2 of next year.
Yields fluctuated following the statement's release and into the press conference. The yield curve remains inverted, continuing the trend over the past year. As long as the Fed remains in tightening mode, we believe the yield curve will remain inverted.
As usual, Powell stressed that whether the Fed hikes again will depend on the incoming data. The committee is "data dependent." Despite the median dot projecting another rate hike this year, the market still isn't sure. According to the fed funds futures market, the implied probability of another hike this year is just 50%. But a higher-for-longer policy should, over time, bring inflation down toward the Fed's 2% target.
Overall, the Fed meeting provided few surprises. Bond yields rose modestly and stocks declined on the prospect of interest rates remaining high. Investors should prepare for a sustained period in which the markets will react to each incoming economic report to try to gauge what it will mean for Fed policy. That could mean more volatility ahead.