The S&P 500, the Nasdaq Composite, as well as the Dow Jones Industrial Average, have all opened higher at the outset of this week. This optimism reflected in stock prices is based on the assumption that the Federal Reserve will halt its interest rate hikes. Indeed, investors expect the Federal Reserve to take a breather at its June 13-14 meeting after ten consecutive meetings with rate hikes.
The Federal Open Market Committee (FOMC) makes the big monetary policy decisions for the Federal Reserve. In June, the committee will most likely leave the federal funds target rate unchanged for the first time since early 2022. It is important to emphasize that pausing interest rates does not mean reducing them. Right now, interest rates are set at 5%. A pause simply means that interest rates will be maintained at 5%, and won’t be hiked to 5.25% or 5.50%. The Federal Reserve does not intend, so far, to reduce interest rates. Thus, there is little chance that the FOMC will change its policy of allowing assets to roll off its $8.5 trillion balance sheet.
Rate hikes and quantitative tightening have been the Fed’s key tools in its struggle to get inflation under control without tipping the U.S. economy into a recession. A soft landing for the economy is the Federal Reserve’s goal—and despite endless forecasts of recession doom, there is no economic downturn in sight as of yet. In fact, the S&P 500 has gained nearly 10% in 2023 thanks partially to optimism that inflation is on the mend.
Investors are already betting that the Fed will be forced to pivot to rate cuts before the year is out. FedWatch sees an 85% chance that there will be one or more quarter of a percentage point rate cuts by December. A rate cut will depend on several economic factors such as consumer spending, unemployment, and of course, inflation. Inflation is heading downward. This is very encouraging. But the level of inflation remains too high to make any change that would encourage consumer spending. In other words, the economy is still in a delicate situation, and making changes that would pertain toward cutting interest rates and boosting spending would be economically suicidal. Thus, the Federal Reserve remains cautious.
The Fed’s balance sheet policy has been a key part of its battle against inflation. By letting its holdings mature—up to $60 billion in Treasury securities and $35 billion in agency mortgage-backed securities (MBS) each month—the Federal Reserve increases costs in credit markets. Fed Chair Jerome Powell estimated that the annual rate of its balance sheet reduction is equivalent to one quarter-point rate increase. The Federal Reserve’s balance sheet has dropped from a record high of $8.96 trillion in May 2022 to around $8.5 trillion in May 2023, but it remains more than twice its pre-pandemic size of $4.15 trillion in late February 2020.
The Federal Reserve’s last economic projections, released in March, called for 2023 U.S. GDP growth of 0.4%, an unemployment rate of 4.5%, and a terminal fed funds rate of 5.1%. They also boosted the 2023 growth forecast for the core PCE price index, the Fed’s preferred measure of inflation, to 3.6% from 3.5%. Investors will be paying close attention to how high the FOMC now sees interest rates rising in 2023 and how low committee members believe rates could fall in 2024 once the Fed eventually pivots to rate cuts.
Comments