When Will Interest Rates Fall?
Our Fed-whisperer Yimin Xu considers.
DISCLAIMER: This note is intended for US recipients only and, in particular, is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Cestrian Capital Research, Inc., its employees, agents or affiliates, including the author of this note, or related persons, may have a position in any stocks, security, or financial instrument referenced in this note. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice. Companies referenced in this note or their employees or affiliates may be customers of Cestrian Capital Research, Inc. Cestrian Capital Research, Inc. values both its independence and transparency and does not believe that this presents a material potential conflict of interest or impacts the content of its research or publications.
Was that the final hike?
Having hiked for the 10th time in the cycle, the Powell finally seems ready for the long-awaited pause. By hiking 25bp to the 5.00-5.25% range on Wednesday, the Fed has now reached the terminal rate they projected in March.
What’s changed? Powell acknowledged that the labour market is still exceptionally tight with demand far outstripping the labour supply (more on this below). Core PCE Inflation is at 4.6%, i.e. more than double the Fed’s policy target.
The crucial point is that by raising the base rate above 5% within a year, the Fed Funds rate is now firmly above the PCE inflation rate, meaning that we have a positive real interest rate. If Core PCE inflation does fall to 3.5% by the year-end and 2.5% by 2024 as projected by the Fed’s latest Summary of Economic Projections, the real interest rate would become meaningfully above the theoretical neutral rate (i.e. 2.5% nominal rate versus 2% inflation), unless the Fed starts cutting.
You could probably see that for this to work, inflation has to keep coming down, and the Fed Funds rate has to stay constant for a while. For the first time in a long time, Powell sounded confident that inflation will come down. At least, he no longer cites the three components of inflation or headaches over “Non-Housing-related Services”.
This means Powell has opened the door for finally pausing in June. Even though Powell has not officially committed to it, I believe pausing is the base case here. The Fed should and does want to assess the cumulative impact of the rate hikes and tighter lending conditions before more things start to break.