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The Fed’s Delicate Walk on a Tightrope

The Fed’s Delicate Walk on a Tightrope
7 min 3 sec

This quarter’s well-publicized mantra—higher for longer—conjures up images of a tightrope, an apt descriptor of the Federal Reserve’s current challenge. Markets and the Fed expect interest rates to be higher for longer than we all anticipated at the start of the year. The economy has been resilient in the face of sharply rising rates, and while inflation has come down, it remains above the Fed’s 2% target. The Fed must carefully balance the risks of too-high inflation with the impact of sharply higher rates on the global economy in 3Q23 while analyzing the ever-changing economic landscape. Plus, throw in a handful of variables that are out of the Fed’s control: supply-driven energy prices, strikes, an October resumption of student loan payments, and a looming government shutdown (thwarted at the 11th hour but only through mid-November). These economic headwinds make balancing on a tightrope challenging.

The Fed held short-term rates steady (5.25% – 5.50%) at its September meeting, in what has been labeled a “hawkish pause.” While the vote was unanimous, the “dot plot” revealed that the median forecast for year-end rates was 5.6%, signaling that one more hike could be in the cards. Expectations for rate cuts in 2024 declined, with the median projection for year-end 2024 being 5.1% versus the 4.6% projection from the June meeting. The markets reflect a slightly less hawkish view. As of Sept. 30, the CME FedWatch tool revealed a 62% probability of the Fed Funds rate being below 4.75% at the end of 2024.

The labor market remains tight though JOLTS job openings fell to 8.8 million in July, down from a March 2022 high of 12 million. Unemployment rose to 3.8% in August, up from 3.5% in July, but remains near historical lows. The increase also reflected a gain in the workforce of more than 700,000. Small businesses continued to report difficulty hiring and jobless claims remained low. Job gains have been robust in 2023, averaging 235,000 per month.

Inflation continued to show signs of moderating from its June 2022 peak of 9.1%. The Fed’s favored measure, the Personal Consumption Expenditures Price Index, was up 3.5% year-over-year in August, the lowest since September 2021 but still above the 2% target. Excluding food and energy, the PCE index was up 3.9%. The Consumer Price Index rose 3.7% year-over-year in August. Gasoline was the biggest driver for the 0.6% monthly increase, accounting for more than half of the gain. Gasoline prices were up 10.6% month-over-month in August. Going into quarter-end, oil spiked to one-year highs on news that stockpiles at the largest storage hub in the U.S. had dropped to the lowest level since July 2022 and were close to “operational minimums.” Forecasters expect oil prices to reach $100 / barrel in the coming months. Core CPI remained sticky; up 4.3% over the same period. Shelter costs (+7.3%) have had the biggest impact on the core measure over the past year.

The Outlook for the Global Economy in 3Q23

Second quarter GDP rose 2.1% in real terms, annualized, following 1Q’s 2.2% gain. Second quarter growth was driven by consumer spending and business investment. Third quarter estimates are for much stronger growth, with the Federal Reserve Bank of Atlanta GDPNow at the high end of the range with a lofty 4.9% expectation (as of Sept. 27). A late September survey of economists conducted by Bloomberg showed expectations of 3% for 3Q, up from the 1.8% rate projected one month ago. Further, just over half (55%) of the respondents expect a recession in the next 12 months, the lowest percentage in a year. The consumer remains healthy with household net wealth near record levels, due largely to high home prices. Retail sales have remained robust across a broad range of categories. However, the pandemic-era savings and stimulus checks that have supported consumer spending have dwindled, and higher rates and inflation have bitten the consumer in a number of ways.

The Atlanta Fed reported that the median American household needed 44% of its income to cover annual payments on a median-priced home (as of July), the highest ever with data going back to 2006. Car payments have also risen sharply with the average payment for a new car exceeding $700/month in 2Q (Experian data). Credit card debt hit a record $1 trillion in 2Q as consumers increasingly tapped credit lines. And as bank lending standards have tightened, loans have become harder to get. Home sales have also been impacted by higher mortgage rates, with the 30-year fixed rate mortgage hitting 7.3% going into quarter-end, according to Freddie Mac, the highest since 2000 and up from 6.0% one year ago. Existing home sales were down 15.3% year-over-year in August, according to data from the National Association of Realtors, while median home prices climbed 3.9% to $407,100. A telling quote from the association was, “Supply needs to essentially double to moderate home price gains.”

The rising budget deficit is getting renewed attention. Rising rates will have a stark effect on the interest expense for the growing budget deficit, which is expected to be $1.5 trillion in 2023 and grow to $2.7 trillion in 2033, according to estimates from the Congressional Budget Office. This equates to 5.3% of GDP, reaching 6.9% of GDP in 2033. Fitch Ratings downgraded the U.S. from AAA to AA+ in August, mirroring the action taken by S&P Global in 2011 after a debt ceiling saga. Moody’s is the only major ratings agency to have a triple-A rating, and the agency recently warned that a government shutdown would be a “credit negative” event.

The picture in Europe is less rosy than in the U.S. Euro zone GDP was a meager 0.5% year-over-year in 2Q23, down from a 1.1% rate in 1Q. The European Central Bank expects growth of 0.7% in 2023 for the 19-country block, of which Germany represents nearly 30%. Germany has posted two quarters of negative GDP growth in 2023 and is expected to post a negative 3Q rate as well. The ECB raised rates by 25 bps at its September meeting to an all-time high of 4.0%, but it also cut prospects for real GDP growth in 2023 to 0.7% and is viewed as being at the end of its hiking cycle. Euro zone inflation has fallen from a peak of 10.6% in 2022 to 4.3% in September, the lowest since October 2021 but above the Bank’s 2% target.

Japan appears to be emerging from a decades-long slump. The country has seen rising inflation with its core measure (ex- fresh food) up 3.1% in August, ahead of the Bank of Japan’s 2% target for the 17th consecutive month. However, Governor Kazuo Ueda has maintained ultra-low rates (-0.1% for the short-term policy rate), which has taken a toll on the yen. The yen has depreciated 17% versus the U.S. dollar since its 2023 low in January. Speculation is growing that the bank will raise rates at its October meeting and potentially also adjust its “yield curve control” policy, which caps the 10-year government bond at a yield of 1%.

China continues to struggle to recover and, as the world’s second-largest economy, it poses a risk to global growth. A property crisis, falling prices, high debt, slumping exports, and sky-high youth unemployment are among the challenges facing the country. While the government announced some modest policy adjustments, including a reduction in key interest rates and mortgage rates as well as lowering down payments on homes, more aggressive stimulus is likely needed. Given these headwinds, China’s expectations for 5% growth appear optimistic.

Closing Thoughts

The U.S. economy has been surprisingly resilient in the face of sharp rate hikes while inflation has moderated but remains above the Fed’s 2% target. A “soft landing” scenario is looking more likely. Against this backdrop, equity markets have held up well, until recently, while rising yields have hurt the bond market. The widespread consensus is for rates to remain “higher for longer.” That said, several thorny issues outside of the Fed’s control make its ongoing mission more difficult. A government shutdown was avoided—at least until Nov. 17—but the outcome is far from certain. Rising energy prices pose another threat to inflation/economic growth. The resumption of student loan payments in October may take a bite out of consumer spending, which has been a pillar of support for the U.S. economy. Not to mention an upcoming Presidential election year and ongoing geopolitical concerns. The road ahead is likely to be bumpy and it will be no surprise that Callan continues to recommend a disciplined investment process that includes a well-defined long-term asset-allocation policy.


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