(This post was posted in Nov 2022)

The Federal Reserve’s November 2022 statement contained dovish language, but Fed Chair Powell warned investors not to expect the Fed to stray from its full focus on fighting inflation.

Upside inflation led the U.S. Federal Reserve to hike its policy rate by 75 basis points (bps) for a historic fourth time. This brought the fed funds rate up to a 3.75%–4% range, meaningfully above the Fed’s 2.5% median long-run estimate, as inflation continues to justify monetary policy with the objective to tame inflation.

In spite of continued inflation, the Fed also indicated in their forward guidance in its November statement that they could continue with their 75-bp rate hikes – we interpret the language in this forward guidance as setting the stage for a pause in the hiking cycle in early 2023. Overall, this statement and Chair Powell’s comments are consistent with our view that the Fed is aiming to pause interest rate hikes in early 2023 as it assesses the impact of tightening till now in this rate increase cycle. Lags between monetary policy action, effect and increased recession risk appear to justify a more measured pace of tightening in the months ahead.

Bond Markets initially sent U.S. Treasury yields lower across the curve seeing the dovish statement changes, before going higher in response to Chair Powell emphasizing that markets should expect further rate hikes. This Bond Market’s response to the statement and press conference appears to show that the Fed is managing a challenging communication balancing act between planning to change the pace of tightening while keeping financial conditions sufficiently tight amid elevated inflation.

It is our view that the Fed will raise the policy rate by 50 bps in December and then pause early next year in the 4.5% to 5% range, but we do not consider that the Fed will commence cutting rates with the current high inflation environment.

Preparing to pause
There are three main reasons why we believe the Fed – as well as other major central banks – will pause interest rate hikes once the policy rate has reached a meaningfully restrictive level:

1. First, monetary policy always appears to work with lags and Central Banks should not change policy based on what inflation is doing today, but rather what they forecast inflation to do one to two years from now. However, a forecast-dependent strategy becomes difficult when inflation model credibility comes into question, as it arguably has today.
2. Second, at the present time recession risk is elevated, and the speed and magnitude of the financial tightening against already weak real GDP growth risks overdoing these hikes, if the Fed were to continue with their 75-bp hikes regime.
3. Third, central bankers must also manage the risk that inflation eventually falls just as rapidly as it has risen because inflation generally falls slower than when it went up.

With U.S. inflation like to stay above the Fed’s target in coming months, the Fed faces a difficult conundrum. The challenge is to communicate the pause while inflation is still high, but to communicate it in such a way that the Fed convinces markets that they are still focused on bringing down inflation and are not going to quickly pivot to dropping rates during increasingly weak economic activity.  Consequently, the Fed is trying to convince markets that they are expecting further hikes while they are attempting to slow simultaneously the pace of hikes, or even pausing, which is what this communication after the November meeting the Fed appears to telegraph now.