The FOMC Pauses Again. At its September meeting, as expected, the FOMC held the target range for the Fed Funds rate steady at 5.25%-5.50%. In the press release accompanying the statement, the Committee noted that while inflation remains elevated, tighter credit conditions for households and businesses will likely weigh on economic activity, hiring and inflation in the months ahead; but just how much is still uncertain. The Committee also reaffirmed its commitment to maximum employment and 2% inflation over the long-run.
The FOMC also issued its latest summary of economic projections. Overall, there were few changes of substance from the previous set of projections. Compared with its previous forecast, FOMC participants expect economic activity, as measured by GDP, to be slightly stronger and unemployment to be modestly lower over the forecast period. Both are more consistent with the notion of a soft landing.
The Committee members’ inflation expectations were also little changed. Headline PCE inflation is expected to be slightly higher over the forecast period, falling from 3.3% in 2023 (vs. 3.2% previously), to 2.5% in 2024, 2.2% in 2025 and then to 2.0% in 2026. Core PCE is now expected to be 3.7% in 2023 (vs. 3.9% previously) and ease steadily to 2.0% in 2026.
On average, the Committee expects the Fed Funds target rate to be 5.5% in 2023, ease by 25 bp to 50 bp in 2024 and then fall to about 4.0% in 2025. Yet, the dispersion of forecasts among FOMC members is quite wide in 2025 and even wider for 2026.
Higher for longer. Headline inflation ticked higher in September, mostly because of the recent surge in oil prices. However, core measures of inflation have continued to ease steadily and are now close to the Fed’s 2% target, on an annualized three-month basis. (See more on inflation below.)
Even though core inflation is now nearing 2%, the pick-up in energy prices, if sustained, could eventually lead to its resurgence. Other factors – such as the upward pressure on labor costs, most visibly seen in the recent contract negotiations between the unions and a number of large publicly-traded companies (e.g. UPS and the automakers), and further potential volatility in agricultural prices, perhaps as a consequence of the war in Ukraine – could also make it difficult to sustain a 2%-ish core inflation rate; so it is prudent for the Fed to remain diligent.
Consequently, several FOMC members have been emphasizing in their public speeches that the current policy regime will need to stay in place for some time and one or two have suggested that another quarter-point hike may be necessary.
Yet, if the 2% core inflation rate objective proves to be unsustainable and economic activity deteriorates, the Fed may be forced to choose between its potentially contradictory mandates to maximize employment and minimize inflation.
Inflation Readings were Mostly Positive in August. The rise in oil prices, which began in early July, made its way into the CPI in August. The headline Consumer Price Index rose 0.44%, higher than July’s 0.19% increase. The annualized 3-month change was 3.9%, higher than July’s 3.1%.
Core CPI rose 0.23% in August, more than July’s 0.16% increase. Yet, the annualized 3-month change in core CPI was 2.6%, down from 3.3% in July. Thus, core CPI inflation is now within striking distance of the Fed’s 2% target.
Prompt month futures for West Texas Intermediate crude oil increased again in September to an intraday high of $95.03 on Sept. 29, but they have since fallen back to around $86 in the first few days of October. The rise in heating oil futures prices has moderated over the past two months, but gasoline futures prices fell sharply in the final weeks of September. Natural gas futures plunged on Oct. 3, gapping down to $2.31, approaching a 52-week low, but they abruptly reversed course at the end of the week, rallying to $3.34.
Meanwhile, the CRB index, a basket of commodities heavily weighted in oil, rose 0.9% in September, which equates to an annualized rate of 11.4%. Here too, most of the increase was due to the rise in oil and oil-related finished products (except gasoline). Agricultural prices declined broadly in September, while copper, lumber and precious metals also declined.
Energy and shelter costs drove 95% of the increase in the headline CPI in September. Shelter costs accounted for an estimated 41% of the increase in headline CPE and 99% of the increase in core CPE. On an annualized three-month basis, shelter costs increased at a 4.8% rate, down from 6.1% in August. That marked their sixth consecutive month of easing.
A partial offset to the rise in oil prices has been the increase in the U.S. dollar. Since mid-July, the continuous near-term U.S. dollar futures contract has risen 7.5%. A stronger dollar puts downward pressure on the overseas revenues and profits of multinational companies, but it also reduces the cost of imports and thus helps to curb inflation. With September’s extended gains, the U.S. dollar is now clearly overbought from a technical point of view, and so is due at least for a correction.
The personal consumption expenditures (PCE) price indices, the Fed’s preferred measures of inflation, continue to move in line with the CPI. In August, the annualized 3-month change in the headline PCE index was 3.2%, up from July’s revised 2.0% increase. The 3-month core rate, which was rebased to 2017 from 2012, eased from 2.8% in July to 2.2% in August, the sixth consecutive monthly decline. Changes in headline and core PCE price indices are shown in the chart below.
Fixed Income. Losses widened across fixed income in September, the fifth consecutive month of declines. Bloomberg’s Aggregate index fell 2.7%, worse than August’s 0.7% decline.
The losses were driven by an upshifting of the U.S. Treasury yield curve that was more pronounced across the longer maturities. Yields rose by 9 bp (to 5.46%) for the one-year note to 53 bp (to 4.73%) for the 30-year bond.
Since quarter’s end, Treasury yields have gyrated but ended the week with the 30-year Treasury yield at 4.95%, up from 4.73% at Sept. 29 and the 10-year yield at 4.78% up from 4.59%. On Friday (10/6), Treasury yields rose on the stronger-than-expected payrolls data, but stocks ended higher on the day too.
Futures markets now expect (with greater than 50% probability) that Fed Funds will hold at or below the current 5.25%-5.50% target rate through May of next year. From June on, the futures assign a greater than 50% probability that the target rate will be below the current 5.25%-5.50%.
The interest rate-sensitive investment grade corporate bond sector once again underperformed the broader fixed income market in September. On average, U.S. corporates declined 2.8%, with long maturity corporates down 5.4%. The declines were driven by the rise in Treasury yields.
High yield corporates also posted losses in September of 1.2%; but like the investment grade sector, the greatest losses were borne by higher quality credits, a sign that higher interest rates were the primary cause and not credit quality concerns. BB-rated issues fell 1.4% in September; B-rated bonds lost 1.0%; and CCC-rated bonds were down 0.6%. Once again, the relatively strong performance of the CCC-rated sector was surprising, given the broad-based declines in equities.
Published and Posted on October 10, 2023
Stephen P. Percoco
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