CONTRIBUTORS
Nikhil Mohan
Economist
Franklin Templeton Fixed Income
The June Federal Open Market Committee (FOMC) meeting delivered a hawkish surprise to markets as the 2024 median interest-rate projection moved up to show just one 25-basis point (bp) interest rate cut, versus market expectations of additional cuts. However, the quantum of cuts across 2024-2026 remained unchanged at 225 bps, implying four rate cuts each in 2025 and 2026 (as opposed to three previously). Although we expected the Federal Reserve (Fed) to validate market expectations and signal two rate cuts, the median projection of just one rate cut is in line with our base case for just the one cut in December.
Following the meeting, markets did not initially buy the new rate projections as they likely were waiting to hear from Fed Chair Jerome Powell as to whether the May Consumer Price Index (CPI) report (released just a few hours prior) had been taken into consideration. Powell acknowledged that FOMC participants had the ability to change their forecast mid-meeting and that “what’s in the Summary of Economic Projections (SEP) actually does reflect the data we got today.”
The fact that the participants chose not to change their forecasts in response to the weaker-than-anticipated CPI print (despite the ability to do so) was likely viewed by many as a hawkish surprise. The 10-year Treasury yield rebounded, taking back half its initial selloff. However, it really shouldn’t be viewed as a surprise because it was unlikely that merely two months of softer inflation (i.e., “modest further progress”) was going to make the Fed sway dovish, especially since we’ve also seen stronger-than-anticipated job gains, faster wage growth and stronger Institute for Supply Management (ISM) Services data more recently. In fact, Powell even noted that wages “are still running above a sustainable path,” and that further wage disinflation is necessary to bring inflation back to target. Moreover, the Fed has consistently stated that it needs to see a prolonged period of disinflation.
However, during the press conference, Powell downplayed the Fed’s Summary of Economic Projections (SEP)—commonly called the “dot plot,”— which suggests that his own projection was likely for two rate cuts this year. He noted that the dot plot reflects neither a plan nor a decision of the FOMC and that the difference between one cut or two cuts this year remains a “close call” since seven participants anticipate one cut and eight expect two. Meanwhile, Powell was also clear that it was the upward revision in 2024 inflation forecasts (core inflation: 2.8% vs. 2.6% in the March SEP) that led to the upward shift in rate expectations relative to March.
As we’ve noted previously, unfavorable base effects in the second half may well keep the year/year inflation measure elevated. That is precisely what Powell also cited as the reason for the stronger 2024 inflation forecast—that even “good, but not great” month/month inflation print could lead to a slight increase in the 12-month inflation measure. Although he noted that this is a “conservative” way of forecasting the path for inflation, it certainly does afford the Fed more optionality, in our view. Note that the impact of low base effects was somewhat underappreciated in early 2021, when inflation began to accelerate. Therefore, it makes sense that the Fed wants to wait for the statistical quirk to fully play out before beginning to ease policy.
Lastly, the longer run or neutral rate also moved up to 2.75%, as three participants who were previously estimating 2.5% revised up their rate expectations. Although Powell downplayed the significance of the longer-run rate, stating that it is unobservable and a “theoretical concept,” we also know that several Fed members and markets too have become more comfortable with the idea that the neutral rate has risen from its pre-pandemic level.
As we’ve noted before, the long-run median rate hovered around 3% through 2016 and 2017, and that was when aggregate domestic demand was thought to be deficient and productivity gains were much more tepid than they have been recently. Therefore, with the economy continuing to exhibit strength at “restrictive” policy rate levels and fiscal dominance expected to continue, we anticipate the longer-run “dot” should grind higher at future FOMC meetings. Note that the New York Fed’s (Laubach-Williams) measure of R*, which has historically been driven by trend/underlying economic growth, currently implies a nominal neutral rate of around 3.5%.
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