Fed Sets Up for a Pause

Posted by Jeffrey J. Roach, PhD, Chief Economist

Thursday, May 4, 2023


  • The Federal Reserve (Fed) increased its policy rate for the tenth consecutive time, pushing the upper bound of the fed funds rate to 5.25%, the highest since August 2007.
  • In the press conference, Chairman Powell was careful to strike a balance between the committee’s commitment to fight inflation and the committee’s view that policy is sufficiently tight.
  • So far, the labor market has been a bright spot for the committee, giving them reason to increase rates yesterday, despite uncertainty within the banking sector.
  • It takes time for the real economy to react to tighter financial conditions so we can legitimately infer that the Fed can pause in June, especially since investors are still waiting for the cumulative impact of the last 10 hikes.
  • Looking ahead, the Fed will release its updated Summary of Economic Projections at the next meeting, likely providing greater guidance for monetary policy over the balance of 2023.
  • As inflation further decelerates, and the job market cools, investors should anticipate some rate cuts in the latter half of the year. We will not likely see a negative jobs report this coming Friday, but by summer, investors should expect a weaker labor market, giving support for those expecting rate cuts by the end of this year.

Softer Language

The Fed raised rates for the tenth consecutive time, pushing the upper bound of the fed funds rate to 5.25%, the highest since August 2007. Markets were not surprised by that decision but many took note of the conspicuous removal of the key word, “anticipates.”

Investors should note the evolution within the Federal Open Market Committee’s (FOMC) statements over the past several meetings. Let’s go back in time. In January, the “committee anticipates ongoing increases in the target range will be appropriate” and then in March, they thought “additional policy firming may be appropriate” and in May, they no longer anticipate additional tightening, but rather remain focused on economic and financial developments [emphasis added].

A key takeaway is the Fed has set themselves up for keeping their target rate unchanged in June. We already know the Fed is monitoring the long and variable lags to monetary policy, which is just another way of saying it takes time for the real economy to react to tighter financial conditions. So, if the Fed is concerned about the time it takes for tighter credit conditions to slow down the economy, we can infer the Fed will be inclined to pause at the next meeting and wait and see. The good news for market watchers is that the Committee will publish an updated Summary of Economic Projections at that June meeting, likely providing greater guidance on monetary policy for the balance of 2023.

Looking Ahead

Now this begs the question: what about July? That meeting is in late July and we expect that by then we will have slower inflation and weaker job growth.

During the press conference, Chairman Powell referenced the tight labor market as a reason to remain hawkish in the near term. As the Federal Reserve moves to restore price stability, they rely on a host of statistics to gauge risks to their outlook. One metric is the openings-to-unemployed ratio. This metric seeks to provide a concise reading of the supply and demand of the American labor market by measuring how many job openings exist per unemployed individual. In the fight against inflation, the Federal Reserve has regularly relied on labor figures when marking their progress. In comments from a November 2022 press conference, Powell remarked the labor market is “especially important” when looking at inflation. This ratio must fall further to convince the Fed that the labor market will not create inflationary headwinds.

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Conclusions and Market Implications

The U.S. is poised to slip into recession later this year, which has implications for future rate decisions. Markets are convinced the Fed will cut rates and we agree but perhaps not in the magnitude of cuts. How will markets react? Although 2023 has its fair share of risks, we do not think markets will retest last year’s lows, despite the likelihood of a recession later this year. Perhaps the relationship between the equity markets and the 1990-91 recession is most informative for today’s most likely scenario as shown in the chart below. As recession risks rise, we think the Fed will eventually cut rates later this year, which may provide some added support for markets.

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