The Federal Reserve will take a break from rate hikes at tomorrow's meeting, but Wall Street fears that policymakers will push out the timing for rate cuts next year, delivering a hawkish pause. With the S&P 500 having slipped below key support as the 10-year Treasury yield hits 15-year highs, a market-unfriendly outlook from the Fed could add to selling pressure.
Yet economists may be missing the forest for the trees — or the dots in this case. Trying to predict the so-called dot-plot that represents the quarterly projections of each Fed policymaker has taken the focus away from the big-picture trend of rapid disinflation and its significance for the interest-rate outlook.
Federal Reserve Economic Projections
To be clear, Wall Street firms are surely right that the new batch of projections will continue to pencil in one more quarter-point rate hike this year to 5.625%. The Fed still needs to guard against growth and inflation running too hot, so there's no logic in taking further rate hikes off the table.
But predictions about what the Fed will project for 2024 are puzzling. Take Deutsche Bank. The firm expects Fed projections to show core PCE inflation falling only to 2.6% by the fourth quarter of 2024, unchanged from its June outlook.
Here's why that is odd: As of July, core PCE inflation had already fallen to a 2.9% 3-month annualized rate. Further, economists expect August PCE data to show that rate has kept falling to 2.3% or 2.4% in August, based on data within the consumer price index and producer price index.
In other words, a 2.6% core PCE inflation projection for 2024 would mean that the recent inflation trend would have to reverse higher. And that would happen as the unemployment rate rises from 3.8% now to around 4.4%.
To top it off, Deutsche Bank economists expect the Fed will pencil in one less rate cut next year, ending 2024 at 4.875% instead of 4.625%.
What Is The Real Neutral Interest Rate?
This policy stance would have troubling implications for the S&P 500. It implies essentially no inflation progress even with rising joblessness and a Fed policy rate near 5%.
The Fed has been debating whether the real neutral interest rate — this is, the inflation-adjusted policy rate that neither slows nor juices economic growth or inflation — has climbed from what most economists thought was below 1% in the years before and after Covid hit. If Fed projections line up as Deutsche Bank suspects, that could begin to cement views of a higher neutral interest rate, which will be a negative for S&P 500 valuations.
Still, it's possible to put more weight on Fed projections than they're worth. Deutsche Bank's main reason for not expecting the Fed to lower its 2024 core PCE inflation view is that only three of 18 dots were below 2.5% in June. That means a lower projection might require a broad reappraisal after just a few more months of data.
Fed Chair Powell's News Conference
As always, Fed Chairman Jerome Powell's news conference at 2:30 p.m. ET will have market-moving potential. At his last big appearance in Jackson Hole, Wyo., Powell did his best to sound hawkish, setting up three potential triggers for further rate hikes.
Highlighting strength in retail sales in July, Powell said more evidence of persistently above-trend growth could warrant further tightening. "Evidence that tightening in the labor market is no longer easing could also call for a monetary policy response," he added.
Powell also highlighted stubbornly high inflation for nonhousing services as another potential trigger.
Yet, since then, the Fed has gotten almost nothing but good news. July retail sales were revised down substantially. Sales excluding gas rose a modest 0.2% in August, and growth may should slow with federal student loan payments resuming.
The labor market also showed signs of normalization as job openings plunged to the lowest level since March 2021 and the share of workers quitting their jobs hit the lowest point since January 2021. August jobs data showed a jump in the jobless rate to 3.8%, while the three-month average job gain eased to 150,000 per month, the lowest since the economy was still trying to emerge from the Covid shutdown in mid-2020.
Finally, the Fed's measure of nonhousing services inflation looks set to dip below 3% on the three-month annualized basis in August data due out at month's end.
Taking it all together, it's a good bet that Powell will tone done his concern about an economic reacceleration. He may well repeat his message from July that economic risks — both to the upside and downside — are becoming more balanced.
The one thing markets don't want to hear from Powell is that November's meeting will be a "live" one, a designation that preceded July's rate hike.
Fed Rate Hike Odds
As of Tuesday morning, markets were pricing in just 1% odds of a rate hike on Wednesday, according to CME Group's FedWatch Tool. Odds of a quarter-point hike by the Nov. 1 meeting stood at 29%, rising to 40% for the Dec. 13 Fed meeting.
S&P 500
The S&P 500 slipped 0.2% in Tuesday stock market action, falling further below its 50-day moving average.
That's a sign that the powerful stock market rally has lost momentum and there's risk of a bigger pullback. The 10-year Treasury yield's move to 4.37% on Tuesday, the highest since Oct. 31, 2007, looks like the biggest hurdle for growth stocks right now.
The chance of a soft landing for the economy has improved, which is mostly great news, but it means that interest rates could stay higher for longer if the Fed doesn't have to sweat over a sharp downturn in economic activity.
Meanwhile, the Fed plans to keep on selling the bonds it accumulated during the pandemic, unloading up to $95 billion worth per month. Along with rising deficits, Fed sales and less demand from overseas buyers like Japan and China, the supply-demand backdrop has pushed up yields, and it may take a significant economic slowdown to provide relief.
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