What happened?

As expected, the Fed raised the policy rate by 75 b.p. to a range of 3%–3.25%—the third increase of 75 b.p. in as many meetings. In addition, their estimates and messaging were generally in line with what had previously been telegraphed and anticipated by the market. As we’ve discussed recently, the Fed has reacted to the latest economic data by recognizing that they still have their work cut out for them to curtail inflation. This was reflected in an increase in the median dot for year-end 2022 from 3.375% in the June meeting to 4.375% in this September meeting. Likewise, the median dot for year-end 2023, which appears to be their estimate of the peak rate this cycle (i.e., the terminal rate), rose from 3.75% in June to 4.625% today. The Fed also lowered their real GDP growth expectations significantly and increased their forecasts for unemployment and inflation.

Hike and hold

The Fed’s anticipated approach appears to reflect a belief that by raising rates to a slightly restrictive level and maintaining them there for an extended period, they can achieve a gradual reduction in inflation over time to hit their 2% target in 2025. This time horizon is key to their policy response—if they felt more urgency, for instance desiring to return to target by the end of 2023, they would need to hike much more aggressively.

What will happen after rate hikes stop has been the biggest split between markets and the Fed’s own expectations. Market participants have been eager to price rate cuts in 2023, based on the idea that the economy will slow and that the Fed will pivot in response to that slowdown. Fed speakers over the last few weeks, and Chair Powell again today, made clear that the committee is mindful of the experience of the 1970s, in which the Fed did pivot in response to a slowdown before inflation was truly defeated. The result was a reacceleration of price pressures that unanchored inflation expectations and eventually forced the Volcker Fed to push rates far higher than would otherwise have been necessary. Today’s Fed very much wants to avoid repeating that mistake, and as a result does not expect to be as quick to pivot to rate cuts when growth slows. Instead, they anticipate pausing—keeping rates unchanged—until they are certain that inflation has been defeated. The Fed’s forecasts suggest that they don’t anticipate that happening until 2024. 

The near term

While the Fed did a fine job telegraphing its reaction function for this meeting and allowing the market to home in on their eventual decision, forecast updates, and messaging, their upcoming decisions will still depend significantly on the data that emerges between now and then. The next decision date is November 2, giving them only one month’s payrolls and inflation data to consider. They’ll then have another two months of data to digest for their December decision. While the Fed anticipates another 100–125 b.p. of hikes this year, that is subject to those data releases. Accordingly, we expect the fundamental volatility around those data points to remain elevated and to be reflected in market volatility as that news is absorbed. Given that monetary policy works with a ‘long and variable lag,’ the data should get ever more interesting as we progress toward 2023.