Another Downshift

After a series of historically large 75 basis points interest rate increases, following the March lift-off, the US central slowed down its drive in December, with a smaller half-percentage point move. In its latest decision on Wednesday, the Fed downshifted again, raising rates by 0.25%, to 4.50-4.75% and the highest since 2007. ^[1]

The decision was unanimous and widely expected, as officials had not pushed back against market pricing for such an outcome, but the hawkish guidance was maintained. The Committee repeated its view that "ongoing increases in the target range will be appropriate" in order to achieve a "sufficiently restrictive" policy stance that will bring inflation back down to the 2% target.

During his press conference, Chair Powell acknowledged recent encouraging developments on various economic indicators, but reiterated that the policy setting is not yet sufficiently restrictive, while speaking of "a couple of more rate hikes" to get there. Moreover, he noted that it "will not be appropriate to cut rates this year" if the economy evolves broadly in line with what they anticipate. ^[2]

Moreover, he once again warned against premature loosening and spoke of the risk of doing too little, which is very difficult to manage, whereas if they go too far, there are "tools that would work on that".

Hawkish But Less Forceful

Although the guidance for more tightening was maintained and Mr Powell remained clearly hawkish, he seemed to be less assertive this time around and the overall message not forcefully hawkish. Market pricing for rates to peak at 5% (which means one more increase) and rate cuts towards the end of the year are maintained after yesterday's decision, according to CME's FedWatch Tool. ^[3]

The Fed is more aggressive than that, since the last Summary of Economic Projections (SEP) points to a higher median terminal rate of 5.1%, which suggest two more increases ^[4]. When asked yesterday about whether this is still the best guidepost, Chair Powell did not explicitly validate these projections, opting for a somewhat vague response.

He was also asked about whether policymakers discussed conditions for a pause, which he did not deny. He opted for a rather vague response which in fact shows that the topic was probably brought up, since he noted that they "spent a lot of time talking about the path ahead".

Furthermore, Mr Powell may have pushed back against market pricing for rate cuts this year, but did not rule it out either. He said that if inflation comes down faster than anticipated, then this "will play into our policy setting, of course", essentially leaving the door open to such an outcome.

Disinflation Underway

The US central bank embarked on the current aggressive tightening cycle in order to bring down sky-high inflation. Price pressures have been abating recently though, with the Fed's preferred gauge – the Core Personal Consumption Expenditures – easing to 4.4% y/y in December and the lowest in more than one year.

The Fed's Chairman may have warned that inflation is still "too high" and more evidence is required for confidence that it is on a "sustained downward path", but acknowledged the moderation. He talked of the start of a "disinflationary process", which is evident in goods prices so far.

It is too early for the Fed to call victory over inflation and to say it is under control, but it is clear that prices are on a downward path. The road may still be bumpy ahead, but the recent moderation is encouraging, allowing the Fed to climb down from its previous outsized hikes.

Focus on Employment

Given this progress on inflation, focus now seems to center around the labor market, which remains "extremely tight" and the Unemployment Rate hovering around fifty-year lows. Mr Powell also pointed out "very high" job vacancies and "elevated" wages, far from where the Fed would like them to be.

The question now is, whether the central bank can achieve the restoration of price stability, with a labor market in such a tight state, while the Fed's own projections show that Unemployment would need to rise significantly for that to occur.

Chair Powell took note of this combination of moderating inflation and strong labor data, which he finds "gratifying", adding that there is a path to bringing inflation back to 2%, "without a really significant economic decline, or a significant increase in unemployment".

The End is Near

The US central bank pointed to more rate hikes and vowed to get the job done, maintaining its aggressive stance. However, there has been a gradual shift in rhetoric, which culminated to Wednesday's press conference.

Chair Powell was hawkish, but not as forceful and assertive as in past appearances, missing several opportunities to hammer home a more aggressive message. He did not explicitly validate the latest staff projections that point to a higher terminal rate, than the one expected by market. Even though he pushed back again rate cuts within the year, he did not exactly rule it out.

The above commentary implies that the end of the rate hike cycle is not far and remains to be seen if the Fed will side with the markets, or the opposite. It is not easy for policymakers to pre-commit to the next steps. since these will be data-dependent. Although there are encouraging signs, markets may be too optimistic about the progression of inflation and potentially underestimating the Fed's resolve to avoid any surprises.

Market Reaction

The announcement of the smaller rate hike and the release of the policy statement, in which guidance for more moves was maintained, initially caused two-way action. The hawkish language though was not forceful enough to douse market expectations around the peak rate and a pivot.

As such the USDollar dropped, whereas the stock market benefited, with SPX500 closing Wednesday with profits of more than three percent.