• Fed Funds overnight range unchanged at 5% – 5.25%.
• Fed members see rates rising this year with at least two more increases to 5.6% area.
• Sees unemployment rising from 3.7% today to 4.5% next year. 
• Inflation remains “elevated” and job gains “robust.”

Waiting

The FOMC paused its rate increase campaign today, leaving the Fed Funds overnight range at 5% to 5.25%. This is the first pause after 10 consecutive rate increases by the Fed. Members justified standing pat by wanting to see the effects of their prior increases on the economy. History suggests each rate increase takes up to a year to filter through the economy, so businesses and consumers have yet to feel their full impact. 

Each quarter the Fed’s staff and Committee members update their forecasts. Two stand out: 1) the members’ projections of the overnight interest rate at the end of 2023 and 2) the unemployment rate next year. The members now project a median short-term rate at year-end to be near 5.625%, a full half-percent above the March projection of 5.1%. Two possible drivers of this change are that back in March members were worried about a banking crisis after Silicon Valley, and sticky inflation. 

The change in unemployment rate from 4.1% at the end of 2022 to 4.5% next year implies a more serious recession ahead. On a curious note, members raised their 2023 GDP forecast from 0.4% to 1%. The Fed staff may be reacting to recent employment strength and pushing their forecast for a recession until 2024. 

What is “real”

Posted interest rates alone are not the full story for borrowers and businesses. Market-driven interest rates on Treasury securities are impacted by supply and demand. Now that the debt ceiling has lifted, the Treasury is trying to rapidly build up its Treasury General Account. It is increasing the amounts it borrows in the Bill and Note markets to raise the TGA from $40 billion to $400 billion by the end of the month. This additional supply is pressuring rates higher. 

After the deposit flight in the spring, bank loan conditions appear to be tightening around the country. Small business runs on loans and, if credit conditions are tightening, new loans will likely be at higher rates. Taken together, these trends have the effect of at least another quarter-point rate increase. It makes sense then that the Fed might pause to see if Treasury borrowing and credit conditions moderate over the next several weeks. 

Analysis

The broad growth rate in prices, as measured by the Consumer Price Index, peaked last June at 9.1%. May’s CPI reading of 4% suggests that short-term interest rates are finally above nominal inflation. Historically, once short rates are above inflation, the Fed stops raising rates. Our reading of inflation components suggests inflation readings may dip lower in the next few months but rise back above 4% in the fall. In his press statement, Chairman Powell says that nearly all members expect further rate increases later this year. This implies Fed staffers may share our view that further rate increases may be necessary despite rates already being above the CPI. 

Today’s 4% level remains well above the Fed’s 2% target. Chair Powell reiterated in his press conference that 2% inflation remains their goal. We think that goal may prove elusive in the coming years, thanks to aging demographics, reshoring of supply chains and falling productivity. 

Summary

The Powell Fed continues to do a good job communicating its decisions and managing expectations. The economy continues in second gear, not too fast, not too slow. Employment remains the only bright spot in our “look ahead” economic dashboard for the next six months or so. 

Markets are not surprised but not impressed either. Long-term interest rates fell after the announcement, suggesting slower growth in the future. Short-term rates rose, but not as far as models would suggest. This has been a recurring theme this year — markets dare the Fed to raise higher — and until today the Fed has taken that dare. 

Stocks like lower interest rates and are at least drawing some measure of relief that rates did not rise today. We have repeatedly stated that this year end would have rates at 5% or higher. We also think that the slowdown will be in the fall. We take the Fed at their word that rates will be higher for longer. Powell said talking about “rate cuts a couple of years out.” The Fed’s call for a recession in early 2024 would, if correct, set a record for waiting for the Most Anticipated Recession Ever. 

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Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. Steve has earned the right to use the Chartered Financial Analyst and Chartered Market Technician designations. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary’s University School of Law. Follow him on Twitter here. 

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