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The US Federal Reserve (Fed) downshifted at its February meeting, raising its benchmark interest rate by just 25 basis points (bps), as inflation has begun cooling in the US. This move was widely anticipated by markets, which have begun pricing in significantly more accommodative policy, including rate cuts in the second half of 2023.

Capital Group’s rates team does not believe the central bank is likely to declare victory over inflation and reduce rates anytime soon. Views on the pace of Fed policy vary within our fixed income team of portfolio managers and analysts, and this opinion is closest to that of the fixed income rates team.

Fed Chair Jerome Powell’s comments on Wednesday (1 February) indicate the central bank remains concerned that inflation still has a long way to go to reach its 2% target. His tone in the press conference did skew dovish: he opened the door to lower forward-looking rate projections at the March meeting and expressed more confidence in the deceleration of inflation.

“While recent developments are encouraging, we will need substantially more evidence to be confident that inflation is on a sustained downward path,” Powell said. “Given [our outlook], I don't see rates coming down. If we do see inflation coming down much more quickly, that will play into our policy-setting, of course.”

This latest hike brings the federal funds target rate to a range of 4.5% to 4.75%, its highest point in more than 15 years. The move to 25bps represents a step down from the 50bps hike executed in December and the 75bps increases implemented at each of the four Fed meetings prior to that.

This follows a favorable Consumer Price Index (CPI) report that found overall inflation had slowed to 6.5% in December, its sixth consecutive monthly decline. But underlying data suggest there could be some potential challenges ahead.

One number to watch will be core services inflation excluding housing (an inflation gauge that strips out housing costs alongside volatile items like food and energy), which Powell has said may be the “most important” inflation metric. It has softened in recent months but is still at around 4% on a three-month moving average basis.

Here are the latest views from Tom Hollenberg, a fixed income portfolio manager and member of Capital Group’s US rates team.

 

• The market is expecting a quick pivot to rate cuts, which appears possible but unlikely. Since the end of former Fed chair Paul Volcker’s tenure in 1987, the Fed has typically taken multiple months to pivot from hikes to cuts.
• Given dismissive “Fed speak” around cuts and the broad easing of financial conditions in 2023, rate cuts appear unlikely this year, barring a significant economic slowdown or a sharp drop in inflation. Even the most outspoken and direct members of the Federal Open Market Committee (FOMC) have been signalling they want to see multiple months of softer inflation data before considering a cut.
• The recent easing of financial conditions (such as lower mortgage rates) may in fact keep the economy growing longer and preclude the need for rate cuts.
• I expect the Fed to look at three major factors going forward to determine policy. For rate cuts to become more likely, I believe we will need to see:
  1. Core services inflation excluding housing moving toward its 2% target.
  2. Declining wage growth. A recent slowdown in average hourly earnings growth as measured by the Employment Cost Index (ECI) was a welcome sign, but we may be in early innings.
  3. An improvement in the labour demand-supply imbalance. The number of job seekers compared with job openings has started moving in the right direction, but we are still far from pre-COVID equilibrium levels.
• Fed members could agree to further rate increases beyond what is priced in markets if the January CPI report (to be released Tuesday, 14 February) shows a rebound in inflation. Markets are currently pricing just over 30bps of further rate hikes by June. Early data from January already shows prices have potentially moved higher in energy, used cars and wages. Jawboning the 2023 rate path higher could help prevent further financial conditions easing and ensure Fed policy is restrictive enough.

 

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