Stop me if you’ve heard this one before, but the Federal Reserve walks into its latest policy meeting, markets prepare for a dovish pivot, the Fed walks out, has a bit of a laugh, and quickly proceeds to remind everyone exactly who is in charge.
That has been the cadence of things through much of this rate hike cycle, and despite choosing to skip a rate hike at two of its last three meetings, including this week, as policymakers tip toe toward an eventual end, the Fed still found a way to tighten the hawkish screws on markets.
Really putting the soft in soft landing
While the aftermath of this week’s meeting has seen equities come under pressure, with the S&P 500 down approximately two percent from pre-meeting levels while Treasury yields across the curve have reached fresh decade-plus highs, the nuts and bolts of the meeting were actually broadly in line with what the market was looking for—in that the path toward a soft economic landing has indeed widened based on recent economic data.
As the first chart shows, the Fed’s economic projections gave the market what it wanted and were notably upgraded. Economic activity based on nominal GDP growth in 2024 was boosted by 40 basis points to 4.0 percent, compared to 3.6 percent based on the June meeting projections. Better growth was paired, unsurprisingly, with a better outlook for the labor market. The unemployment rate is now seen ending 2024 at just 4.1 percent, down from the previous 4.5 percent projection, and never deteriorates from that level throughout the Fed’s forecast horizon into 2026; it stands at 3.8 percent as of the latest payrolls report for August.
Key changes to the Fed’s economic & rate projections
Chart showing the evolution of key Federal Reserve economic & rate projections between the June and September meetings. Economic growth improves to 4.0% from 3.6% in 2024, while the expected rate of unemployment fell to 4.1% from 4.5%. The Fed also sees policy rates remaining higher for longer, ending next year at 5.1%, compared to 4.6% previously.
Source - RBC Wealth Management, Federal Reserve; range shows central tendency, which excludes outliers
Now we can all debate whether those numbers are realistic or a bit too lofty, we would probably fall in the camp of the latter, but if the Fed is all in on a soft landing, what’s the deal with the increase in the policy rate to a full 5.1 percent at the end of next year which would suggest just one rate cut next year from its current level?
This is a story about what happens when rates stop being polite, and start getting real
You would be forgiven if you had assumed Fed policymakers also paired expectations for a stronger economy and a lower unemployment rate with a higher inflation forecast, but alas, they did not.
And that is likely at the heart of the market’s modestly negative reaction to the latest Fed meeting.
The Fed actually lowered inflation expectations for this year and left 2024 projections unchanged at 2.5 percent for headline personal consumption expenditures (PCE) inflation, and 2.6 percent for core (ex. food & energy) inflation. For a Fed that has been laser focused on inflation, and has seen notable improvement in recent months, such a significant increase in prevailing rate levels seen over the forecast horizon was perhaps a bit of a surprise even if markets have been repricing the “higher for longer” scenario for a number of months.
We think the real issue, for the economy and risk assets, is the level of real rates. As the last chart shows, based on the Fed’s projections, real rates—which is the fed funds rate minus the headline PCE inflation rate—is now 50 basis points higher in upcoming years and near some of the highest levels since 2007. And if inflation slows more than the Fed expects—which the current Bloomberg consensus survey shows—real rates would only move higher. Equity valuations are highly sensitive to real rates, as is economic activity, therefore higher real rates also raise the risks of a policy mistake by the Fed.
Push it to the limit? Fed projections show extended run of high inflation-adjusted policy rates
Line chart showing the “real” fed funds policy rate which is adjusted for inflation. Based on the Fed's updated forecasts of higher policy rates but steady inflation numbers, real rates are projected to reach the highest levels since 2007.
Source - RBC Wealth Management, Bloomberg; “real” rate is fed funds rate minus headline PCE y/y inflation rate
There are two classes of forecasters: those who don’t know, and those who don’t know they don’t know
As always, and as Fed Chair Jerome Powell was once again keen to point out, these numbers are nothing more than projections based on recent data, which certainly has improved, but is all highly uncertain. The Fed’s latest forecasts do have an element of both hoping for the best economic outcomes and planning to implement policy based on the best case scenario.
While market turbulence has picked up as a result, the Fed is fully in data-dependent mode, which is to say it has no more idea of what happens next than anyone else. To wit, current market pricing based on Fed Funds futures data for one last rate hike this year, as the Fed still expects, sits squarely and neatly at 50/50. And where the Fed has rates holding north of 5.00 percent at the end of next year, the market is looking for something closer to 4.75 percent.
All told, our thinking as it relates to the Fed remains broadly unchanged: Rate hikes are likely over, and the risk bias is still toward multiple “insurance” rate cuts next year as economic activity and inflation slows.
The benchmark 10-year Treasury yield is now approaching our expected next stopping point of 4.50 percent this week, but could it have scope toward 5.00 percent? That’s not yet our base case, but it seems there’s little to stand in its way for the time being. Regardless, it remains a yield smorgasbord for fixed income investors—or at this stage, all investors—and we continue to recommend locking in yields.