This week, the US Federal Reserve (Fed) announced a further 0.75% rise in its target rate amidst a plethora of news suggesting the US economy is slowing.
The latest rate rise brings the upper bound of Federal Funds up to 2.5%, from 0.25% as recently as March. This move was widely anticipated, however what attracted market attention was the acknowledgement that the economy may be slowing. This led to greater uncertainty about the path of interest rates in the future and, as a result, US Treasury yields declined sharply. The equity market took heart from this and rose despite the negative economic data. Growth stocks, which have suffered as long-term interest rates rose, outperformed. The Fed say they are data dependent, but markets seem to interpret that as the Fed is already changing direction. Is this justified and what does it mean for other central banks?
US headline Consumer Price Inflation is vastly above the 2% target, at 9.1%.[1] Core inflation - excluding food and energy – is at 5.9%, also way above target, and on this measure further tightening is fully justified and some people have suggested rates should rise even faster.[2] However, interest rates take time to impact the economy and can really only impact the demand side of inflation. They do little to reverse supply shortages.
In any event, it can take several months for interest rate moves to feed through to the economy. US mortgage rates are usually long-dated and have nearly doubled since the start of the year. New home sales fell sharply last month, and pending home sales were down 19.8% year-on-year.[3]
As we go through the results season, we are hearing of more companies cutting their workforce (such as Shopify and Ford) and others freezing hiring (such as Microsoft and Apple). Consumer confidence has continued to decline, partly owing to shrinking real wages.
The preliminary Purchasing Manager Index data showed the US in contraction and medium-term inflation indicators have turned lower towards the Fed target. Fed Chair Powell was asked several times after the meeting if the US was in recession which he said was not the case and that they were not trying to drive the economy into a recession.
The day after the meeting, the US GDP data indicated a second quarter of declining GDP, which for some is an indication of recession. The US National Bureau of Economic Research, which officially defines a recession, looks at a much wider definition including falling personal income, industrial production and employment. On these measures, the US economy is not in a recession yet. We should note that, while unemployment remains low, the weekly jobless claims data has indicated deteriorating conditions in line with the hiring plans we see from individual companies.
While the Federal Reserve has been raising interest rates and further increases are expected, monetary conditions have tightened considerably. As inflation has continued to rise, they had managed expectations down with the ten year rate priced into the Treasury inflation-protected bond market declining from over 3% to 2.3% earlier this month.[4]
Monetary conditions tightened as the Fed was expected to raise rates steeply. However, to maintain these conditions, the Fed has to stay on the expected path. So far, they have done that, but with recession fears growing and the Fed apparently acknowledging the slowdown, further steep rises in rates have come into question. The 10-year Treasury yield that peaked close to 3.5% in mid-June is back to 2.70% today.[5]
So, despite two 0.75% increases in the Federal Funds rate, monetary conditions may have actually eased. The average 30-year mortgage rate had risen from 3% at the start of the year to 6% in June but is now below 5.5%.[6] If the Fed wants to maintain tighter monetary policy it needs to be seen to be sticking to the plan.
While the Fed is always data dependent, this is now more the case than ever. While we are not convinced they have turned, they have left the door open for a slowing of the pace of rate increases. Nevertheless, they have not ruled out a continued steep rise in rates. Fed Fund futures had priced in 3.5% by year end but they now price in 3.25%, still a further 0.75% from here. The Fed wants to slow demand and that is what they have done.
Rising unemployment may discourage inflation-busting wage settlements, which would help the Fed to get back to its inflation target. However, the Fed also has a target for full employment that may give them a reason to slow or pause the rate rises. As ever, they are balancing on a tightrope between economic growth and inflation.
We will be watching in particular the employment data as we go through the remainder of the year. Worse economic news may lift bonds and perversely the prospect of a lower peak in rates may help equities as we have seen over the last few days.
We have already seen the European Central Bank raise rates last week and next week we have the Bank of England (BoE). If the Fed is walking a tightrope, the BoE Monetary Policy Committee is walking an even narrower tightrope that is being shaken.
Rail strikes may be the tip of the iceberg of industrial unrest as we go into the autumn. The price cap on energy bills will rise again in October, possibly by over 60%, pushing inflation as high as 12%. Unions will demand wage rises to match and, with shortages of staff, partly made more difficult by post-Brexit immigration rules, these may be hard to resist.
The falling pound against the dollar adds inflationary pressure, so we will not meaningfully benefit from the recent fall in crude oil prices. Unlike the US where mortgages are typically fixed for long periods, most mortgages here are floating or fixed for less than five years. Those coming up to refix will be getting a rude shock when they look at their renewal rate.
Meanwhile, the Conservative leadership election seems to be turning into a bidding war with even Rishi Sunak suggesting he will cut the tax on fuel. Liz Truss is floating the idea of wider tax cuts. If there is fiscal stimulus then it seems likely the BoE would have to raise rates even more. Rising interest rates with declining real income may lead to downward pressure on house prices. The next General Election may not be until 2024, but whoever the new Prime Minister is they won’t want to go into that with declining property prices.
Next week, we expect the Bank of England to stick to its guns and raise rates another 0.5%, but the path after that is less certain.
[1] US Bureau of Labor Statistics
[2] US Bureau of Labor Statistics
[3] National Association of Realtors
[4] Bloomberg
[5] Bloomberg
[6] Bankrate.com/Bloomberg
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