The Federal Reserve, in its latest decision on Wednesday, September 20, 2023, maintained its benchmark interest rate at a 22-year high. However, it conveyed its expectation of one more rate hike before the year’s end and a reduced number of rate cuts for the following year, deviating from its previous guidance.
During its two-day meeting, the Federal Open Market Committee unanimously voted to keep the federal funds rate within the range of 5.25% to 5.5%. The central bank’s projections, disclosed at the meeting’s conclusion, indicated that if this final hike materializes, it will mark the conclusion of the current rate-hiking cycle.
Since March 2022, the Federal Reserve has pursued an assertive strategy aimed at curtailing both consumer and business demand, seeking to combat inflationary pressures that have proven more resilient than initially anticipated.
The committee, in its statement, affirmed its vigilance regarding inflation risks. It acknowledged that economic activity has been consistently expanding at a robust pace, and while job gains have slowed somewhat, they remain sturdy.
The statement further elucidated the committee’s approach to future policy decisions, stating, “In evaluating the extent of additional policy adjustments necessary to bring inflation back to the target of 2% over time, the committee will consider the cumulative impact of monetary policy tightening, the time lags in which monetary policy influences economic activity and inflation, and prevailing economic and financial developments.”
It also emphasized the committee’s readiness to adapt the monetary policy stance as needed should unforeseen risks arise that could hinder the achievement of the committee’s objectives.
Projections and decisions regarding interest rates hold immense sway over the broader economy, affecting various financial markets, including equities, bonds, and commodities.
The Fed’s key tool in this regard is the Federal Funds Rate (FFR), which serves as the base interest rate that ripples through the financial system, influencing banks, bond markets, and the overall economy. The Fed makes these rate decisions during its Federal Open Market Committee (FOMC) meetings, held eight times annually. The rate adjustments in 2022 had already brought about several hikes, with more in store for 2023.
The increase in FFR, in turn, leads to a rise in the prime rate, the fundamental interest rate charged by banks to creditworthy customers. Consequently, the cost of loans and mortgages also increases. This uptick in the cost of servicing loans translates to reduced discretionary income for consumers and businesses, which, in turn, can dampen overall demand and mitigate inflationary pressures.
The implications for stocks are twofold: consumer-dependent sectors like retail and hospitality may face headwinds due to reduced consumer spending, while growth stocks that rely on capital and borrowing could also suffer, as investors shift their focus toward more stable, value-oriented investments in response to market volatility and potential downturns.
From a mechanical perspective, rising interest rates put downward pressure on bond values. As rates climb, the yield on bonds becomes less attractive compared to the prevailing base rate, leading to a sell-off in bonds. This effect is particularly pronounced in the case of long-term bonds, as the discrepancy between their yield and the base rate grows over time. As a result, fixed-income securities also lose value as the opportunity cost of not owning interest-rate tracking assets increases. Thus, predicting interest rates over the next five years becomes a critical indicator for market trends.
The US has experienced periods of both high and low-interest rate volatility in its history. In the postwar era of the 1950s, the FFR remained below 2%, bolstered by postwar stimulus and income growth. Over the next two decades, the rate fluctuated between 3% and 10% during the 1960s and 1970s, soaring to a record high of 19.1% in 1980 amid rampant inflation.
As the US economy stabilized and inflation was brought under control, the FFR hovered around 5% throughout the 1990s. However, recessions in 2001 and 2008 forced rates down to historically low levels, where they remained until 2016. The COVID-19 pandemic necessitated another significant rate cut, nearly to zero, with recent inflationary pressures prompting the Fed to initiate a tightening cycle. In 2022, the Fed increased rates seven times, followed by three hikes in 2023, bringing the rate to its current range between 5% and 5.25%, the highest level in 16 years.
The Fed now faces the challenge of navigating uncertain economic conditions, marked by rising prices and an economic slowdown, compounded by supply chain disruptions. Inflation, as well as the potential for a recession, are top concerns.
Inflation has been a focal point for central bank action. In 2022 and 2023, inflation was driven by a mix of demand and supply factors, sometimes interconnected. The Fed’s more hawkish stance appeared to have contributed to a moderation in price increases. In the May meeting, Fed Chair Jerome Powell indicated that the central bank no longer anticipates additional rate hikes but remains data-dependent.
The rhetoric shifted in July when official data from the US Labor Department revealed that the inflation rate had reached 3.2% year-over-year, driven by increased costs in housing, car insurance, and food. This marked an uptick from June, which had seen the lowest rate in over two years, at 3.0%. Analysts had anticipated this rise in the headline rate, considering the relatively weak price inflation observed in the previous July.
Despite economic turbulence, the US dollar has remained remarkably resilient. Its status as a safe-haven currency, coupled with increased investor appeal due to the Fed’s hawkish monetary policy, has bolstered its performance. However, as the Fed’s monetary tightening slows and potentially pauses, the strength of the US dollar appears to be waning.
Balancing the need to curb inflation without stalling economic growth is a complex endeavor, and the Fed seems to be managing it relatively well. While the US is not currently in a technical recession, economic growth has been decelerating over the recent quarters. The U.S. economy grew at a slightly less brisk pace than initially thought in the second quarter as businesses liquidated inventory, but momentum appears to have picked up early this quarter as a tight labor market underpins consumer spending.
Gross domestic product increased at a 2.1% annualized rate last quarter, the government said in its second estimate of GDP for the April-June period. That was revised down from the 2.4% pace reported last month. Economists had expected GDP for the second quarter would be unrevised.
Analysts primarily focus on near-term interest rate forecasts, but long-term projections extend over the next several years. These forecasts offer valuable insights into interest rate expectations.
As of September 7, 2023, an interest rate forecast by Trading Economics indicates that the Fed Funds Rate could reach 5.50% by the end of the current quarter. The forecast anticipates a gradual decline to 3.75% in 2024 and further to 3.25% in 2025, according to econometric models.
Similarly, ING’s interest rate predictions indicate rates at 5.50% in the second and third quarters of 2023. In 2024, they foresee rates starting at 4%, with subsequent cuts to 3.75% in Q2 2024, 3.5% in Q3 2024, and 3.25% in the final quarter of 2024. In 2025, ING predicts a further decline to 3%.
The University of Michigan inflation expectations in the United States for the five-year outlook were revised slightly higher to 3% in August 2023, compared to the preliminary estimate of 2.9%, matching July’s reading.
But new Fed’s projections, announced alongside its latest monetary policy decision, predict a rate of 5.6% for 2023, with a projected estimate of 5.1% for 2024. Looking further ahead, 2025 is expected to see a median rate of 3.9% while the projection for 2026 stands at 2.9%.
According to experts polled by Trading Economics, US consumer inflation expectations for the year ahead fell for a fourth consecutive month to 3.5% in July – the latest month for which these figures are available –, a fresh low since April of 2021, from 3.8% in June. Year-ahead price growth expectations declined for gas by 0.2 percentage point to 4.5%, food by 0.1 percentage point to 5.2%, the lowest since September 2020, medical care by 0.9 percentage point to 8.4%, the lowest since November 2020; college education by 0.3 percentage point to 8.0% and rent by 0.4 percentage point to 9%, the lowest since January 2021. Also, median home price growth expectations decreased to 2.8% in July from 2.9% in June. Meanwhile, consumers also see lower inflation in three years at 2.9% from a previously expected 3.0% and in five years at 2.9% from 3.0%.
In the short term, analysts believe that the Fed is likely to maintain the current rate after a new hike in September, barring a resurgence of inflation.
The latest edition of the Federal Reserve’s Beige Book reveals a nuanced economic landscape for the months of July and August. While economic growth was characterized as modest during this period, some key indicators showed improvements, even as certain challenges persisted.
The Beige Book, published by the Federal Reserve System eight times a year, serves as a comprehensive resource detailing current economic conditions across the 12 Federal Reserve Districts.
Contacts from various districts reported that overall economic growth remained modest. Notably, there was stronger-than-expected consumer spending on tourism, providing a welcome boost to the economy. However, a different picture emerged in the retail sector, where spending continued to slow, particularly on non-essential items.
Job growth exhibited a subdued trend, and while hiring slowed, imbalances in the labor market endured. Many districts faced challenges related to the availability of skilled workers and a limited pool of applicants.
Labor cost pressures saw elevated growth across most districts, often surpassing expectations for the first half of the year. Encouragingly, nearly all districts reported that businesses were adjusting their expectations, anticipating a broader slowdown in wage growth in the near term.
Regarding price growth, most districts noted a deceleration, particularly in manufacturing and consumer goods sectors. However, some districts highlighted significant increases in property insurance costs over the past few months. Interestingly, input prices tended to slow less than selling prices in several districts. Businesses found it challenging to fully pass along cost pressures, which had the effect of squeezing profit margins.
There were indications from certain districts that consumers might have exhausted their savings and were increasingly relying on borrowing to sustain their spending habits.
In the automotive sector, new auto sales expanded in many districts, but this growth was primarily attributed to improved inventory availability rather than a surge in consumer demand. Meanwhile, manufacturing contacts reported improved supply chain performance, allowing them to meet existing orders more effectively.
New orders, however, remained stable or declined in most districts, leading to shorter backlogs as demand for manufactured goods tapered off. One area where supply constraints persisted was in single-family housing.
A common theme across districts was the limited inventory of homes for sale, which drove an increase in new construction activity for single-family housing. However, the construction of affordable housing units faced challenges due to higher financing costs and rising insurance premiums, highlighting ongoing obstacles in the real estate market.
Bitcoin and other digital assets have demonstrated resilience in a rising interest rate environment. For instance, Bitcoin experienced remarkable growth of 2,000% in 2015 and 2016, during a period marked by rising interest rates.
Nevertheless, some experts argue that persistently high inflation, gas prices, and energy costs resulting from elevated interest rates may dampen risk appetite, potentially posing headwinds for cryptocurrencies.
Central banks wield significant influence, directly affecting money circulation and financial market stability. They have the power to modify interest rates, which, in turn, affects the borrowing rates for financial and banking institutions. Recently, central banks in major developed economies, such as the Fed, ECB, and BoE, have opted to increase interest rates in response to widespread inflation.
The increasingly intertwined relationship between cryptocurrencies and these macroeconomic and monetary shifts is noteworthy. In particular, the decisions to raise interest rates, especially by the Fed, have direct repercussions on the cryptocurrency markets.
In simpler terms, the Fed’s more assertive stance has cast a shadow over cryptocurrencies, impacting market sentiment as tighter monetary policies loom.
As depicted in the first chart below, most central banks have raised interest rates, with only a few exceptions, while the second chart illustrates the decline in Bitcoin’s value over the past year.