Fed FOMC Preview: Pressing the Pause Button is a Done Deal, But Will They Add More After Skipping?

Since the start of the interest rate hike cycle 15 months ago, the Federal Reserve may press the pause button for the first time at this week's meeting, but it may just be a "hawkish skip."

At 2:00 p.m. Eastern Time on Wednesday (2:00 a.m. Thursday Beijing time), the Federal Reserve will announce its interest rate decision and economic forecast summary, followed by a monetary policy press conference by Federal Reserve Chairman Powell.

The market currently expects the Federal Reserve to "skip" the interest rate hike this week, but still leave a window for future rate hikes. This pause does not mean the end of the interest rate hike cycle, and the Federal Reserve's post-meeting statement will remain hawkish for some time.

As a key point where the Federal Reserve may pause the interest rate hike for the first time in 15 months, this interest rate meeting is more eye-catching than before. In addition to the press conference, the Federal Reserve will also release the latest economic forecast summary report (SEP) and interest rate dot plot for the quarter, and investors will search for signs of interest rate paths, inflation expectations, and other signs, and the market may enter a huge shock mode.

Given the current high inflation data and no significant cooling signs in the core PCE inflation rate since this year, economists still hold an open attitude towards the risk of future rate hikes. Analysts believe that from the perspective of the Federal Reserve, whether to raise interest rates is not the core issue, but managing inflation expectations is the most critical.

Pressing the pause button has become a foregone conclusion

Currently, institutions and investors have fully priced in the Federal Reserve's "skip."

They expect that the FOMC will pause the interest rate hike at this meeting and continue to raise interest rates at the July meeting. The Chicago Mercantile Exchange's Federal Reserve observation tool "FedWatch Tool" shows that the market has priced in a 95.3% chance that the FOMC will not raise interest rates in June, and the probability of raising interest rates at the July meeting exceeds 50%.

On May 31st local time, Jefferson, the nominee for Vice Chairman of the Federal Reserve and current Federal Reserve Board member, said that any decision by the Federal Reserve to maintain the benchmark overnight interest rate at the upcoming meeting should not be seen as the Federal Reserve ending its tightening monetary policy. He hinted that the June meeting is inclined to maintain the interest rate unchanged, so that decision-makers have more time to evaluate the economic outlook, but not adjusting the interest rate does not mean that the interest rate hike cycle has ended.

This statement poured cold water on the expectation of an interest rate hike in June.

Goldman Sachs believes that the Federal Reserve's pause at this meeting is a cautious approach, because the lagging effects of large-scale interest rate hikes and the uncertainty of the impact of bank credit tightening have increased the risk of unexpected excessive tightening. UBS's reasoning is that some tightening measures will have the same effect as raising interest rates, which means that the FOMC may not need to raise interest rates significantly. Powell may explain that they will collect more information over time and decide on the next policy steps based on the economic situation and its impact on growth and inflation.

However, Morgan Stanley is skeptical about this.

Morgan Stanley believes that economic data shows that overall economic growth in the second quarter of the United States has stalled, but employment growth remains strong and the inflation rate continues to rise. As time goes by, the threshold for the Fed to continue raising interest rates in July will only get higher, and the peak interest rate of this round of rate hikes is expected to remain at 5.1%. The Fed is expected to cut interest rates by 25 basis points for the first time in the first quarter of 2024.

Morgan Stanley has given a forecast of economic data before the July meeting, which is expected to show that inflation and employment are accelerating again. Even if the possibility of another interest rate hike increases in the next few weeks, the continuous deterioration of economic data reduces the risk-return ratio of further interest rate hikes. Overall, the institution believes that there is limited room for the market to price any higher interest rate peaks or current interest rate cuts at this meeting.

At the same time, as interest rates approach or reach the level that officials believe can suppress economic growth, the differences between hawkish and dovish members on how much the interest rate level can be raised are increasing. Bloomberg's survey of economists shows that nearly 40% of people expect hawkish opposition at this meeting. Morgan Stanley economists also believe that the key is to see economic growth and inflation slow down together, otherwise the Fed may resume its rate hike cycle.

How high is the peak interest rate?

It is worth noting that there is also a focus of this meeting, FOMC will release the latest quarterly summary of economic projections (SEP) and the dot plot of interest rates. Most institutions expect the Fed to raise the median of the federal funds rate target range for 2023 and 2024.

HSBC believes that the new forecast given by FOMC at this meeting is very important, and it is expected that the median of the interest rate forecast for the end of 2023 may be raised to 5.375%, which means that interest rates will be raised by 25 basis points this year, and the interest rate range will remain unchanged at 5.25-5.50% until the second quarter of 2024. HSBC will slightly raise its interest rate forecast for the end of 2024 from 4.25% to 4.375%, while keeping the median forecasts for the end of 2025 and the long term unchanged at 3.125% and 2.5%, respectively.

Market forecasts are more hawkish. According to the latest survey of economists by the Financial Times, economists believe that the FOMC needs to take stronger-than-expected action to eradicate inflation and expect at least two 25 basis point rate hikes this year. Of the 42 economists surveyed between June 5 and June 7, 67% predicted that the federal funds rate would peak this year between 5.5% and 6%, up from 49% in the previous survey.

This year's core PCE inflation rate in the United States has not shown significant signs of cooling, indicating the need for a restrictive monetary policy stance. St. Louis Fed President Brad recently said that after a year of aggressive rate hikes, "given the current macroeconomic conditions, monetary policy can now be said to be at the bottom of a restrictive policy."

HSBC said there are two risks to the policy rate forecast. One is that if core PCE inflation remains stubbornly high, the FOMC may eventually raise the federal funds target range above the expected peak of 5.25-5.50%; the other is that a significant acceleration in the unemployment rate may raise concerns about the risk of a hard landing for the US economy. In this case, the FOMC may consider cutting interest rates earlier and by a larger margin than expected.

Inflation may slow significantly

In terms of economic data, economists generally expect the Fed to raise its 2023 economic growth forecast and lower its unemployment rate forecast, with future inflation levels expected to cool significantly.

Data shows that the Fed's favorite inflation indicator, the core PCE price index excluding food and energy, rose 4.7% YoY in April, exceeding expectations of 4.6% and still well above the FOMC's median forecast of 3.6% for the fourth quarter of 2023; MoM growth hit a new high since January 2023.

HSBC believes that the US core PCE inflation rate will gradually decline to 3.8% by the end of 2023 and to 2.7% by the end of 2024; Goldman Sachs' forecast is similar, expecting core inflation to slow significantly in the second half of the year, from the current 4.7% to 3.7% in December.

In terms of unemployment rate, Morgan Stanley expects that the FOMC will significantly lower the median forecast for the unemployment rate in 2023 to 4.0%, while HSBC's forecast for this indicator is 4.3%. HSBC believes that the labor market has unexpectedly shown resilience since the beginning of this year. The latest report from the Federal Reserve shows that the tightness in the labor market is only gradually beginning to ease. If this situation persists, it may continue to complicate the FOMC's efforts to lower inflation. However, at present, it is expected that some policymakers will lower their forecasts for the year-end unemployment rate.

Will continuing to raise interest rates lead to an economic recession?

Although the market previously believed that the Federal Reserve's aggressive interest rate hikes would push the economy to the brink of recession, Goldman Sachs stated that the downside risks to the US economy have diminished and that the banking crisis will not lead to an economic recession. Therefore, Goldman Sachs has lowered the probability of a US economic recession in the next 12 months to 25%.

Goldman Sachs believes that although economic survey data is weak, this is only because overall business sentiment is low, and the maximum negative impact of rising interest rates on the interest rate-sensitive housing sector has now dissipated. As monetary and fiscal policy tightening reduces the drag on GDP growth this year, the key risk is not an impending recession, but rather a re-acceleration of the economy. The key question over the past three months is whether the pressure on the banking industry will change this situation, enough to automatically slow demand growth, reduce the need for further interest rate hikes by the Federal Reserve, and even push the economy into recession.

In addition, Goldman Sachs also stated that the threshold for the final interest rate cut is higher than expected, so the institution's view on the Federal Reserve's policy stance for the next two years is more hawkish than market pricing, and six FOMC officials will predict that there will be more than one interest rate hike for the remaining time this year.