Fed pauses but signals more to come

The US Federal Reserve held its target rate unchanged at its June FOMC meeting, leaving the upper bound at 5.25%. The decision was unanimous, and the pause had been widely anticipated by ourselves, markets, and observers. What was always going to come under greater scrutiny was the revised dots plot, new economic projections from FOMC members, and the post-meeting commentary by Jerome Powell, all of which were fairly hawkish and left the door wide open for a resumption in hiking before year-end. Our expectation now is that there will be at least one more hike this year, likely at the July meeting. This would take the upper bound to 5.50%, before being held for a period thereafter, although if the US economy continues to outperform and inflation remains stubborn, the risks are to the upside.

Since the Fed started this tightening cycle in March last year it has implemented a total 500bps of hikes to levels last seen in 2007 as it has sought to bring inflation back down from its multi-decade highs. The decision this week marked the first time the FOMC has paused in that run of 10 meetings, making it the most aggressive tightening cycle in decades. There has been progress on inflation in recent months – the May CPI print released the day prior to the decision showed the headline rate at a two-year low of 4.0%, marginally lower than the predicted 4.1%. However, the slowdown has largely been driven by favourable base effects on energy prices. Core inflation was still at 5.3% y/y, which while admittedly lower than the 5.5% recorded in April remains well above where the Fed would like it to be. Core PCE, the Fed’s preferred measure, also remains higher than target, and the new economic projections showed an upwards revision to the Fed’s forecast which now sees it at 3.9% y/y at year-end, compared with 3.6% previously. Indeed, the measure is only expected to fall to 2.2% by Q4 2025, from 4.7% in April on the latest print.

This expectation of stubborn inflationary pressures explains why the majority of FOMC members now expect rates to head higher from here still, with all but two expecting at least one more hike and the majority predicting a further 50bps before year-end, which would take the upper bound to 5.75% (up from 5.25% in the March projection). In his post-meeting conference, Fed Chair Jerome Powell explained the pause at the June meeting as a logical moderation in the pace of tightening which would allow time to assess data, but he struck an equally hawkish tone to the dots plot, saying that the July meeting would be a ‘live’ one and labelling the June meeting a ‘skip’ at one point, raising expectations of a resumption in tightening in July.

Powell cautioned that while there had been some progress on bringing down inflation, it was slower than the Fed had expected, and he warned that the risks were to the upside given the tight labour market. Indeed, the other side of the Fed’s dual mandate has remained remarkedly resilient with a net gain of 339,000 on the NFP for May, and the Fed has revised its unemployment forecast for year-end to 4.1%, from 4.5% in the March forecasts. The May rate was 3.7%, up from 3.4% in April but driven higher by a return in working age jobseekers to the labour market.

With the hawkish messaging from the meeting yesterday, the sticky inflation, the resilient labour market, and economic activity data which has to an extent defied the expected downturn, we anticipate a 25bps hike from the Fed in July. As Jerome Powell and the FOMC statement noted, the effect of the tighter credit conditions stemming from the banking sector unrest of recent months remains to be seen, as does the cumulative lagged effect of the hiking already implemented. This may explain why the market remains more dovish than the Fed, and while cuts are no longer prices for this year, neither is an additional 50bp in tightening.