The Chairman of the US central bank (the Fed) caused quite a stir in financial markets with his speech on 20 September 2023, despite the absence of any new measures or shock phrases along the lines of Mario Draghi’s notorious “whatever it takes”. US equities lost more than 2% over two days, and the Nasdaq over 3%, while 10-year US yields rose above the symbolic threshold of 4.5% during the 22 September session – the highest level since October 2007. So what happened?
At the heart of this commotion were the economic forecasts issued by members of the Federal Open Market Committee (FOMC). By the end of this year, the majority of FOMC members expect another 25 basis point rise in key rates, bringing the upper end of the range to 5.75%. At the same time, inflation is clearly subsiding and members now expect the Fed’s benchmark core PCE to reach 3.7% by the end of 2023. This is the prelude to real short-term rates (the key interest rate adjusted for core PCE) of close to 2% – again a level unprecedented since the unhappy days of 2007. And longer-term projections are not easing, given the extra turn of the screw expected in 2023, but tightening in a similar way. FOMC members are revising up their forecasts for key rates by the end of 2024 and 2025 by 50 basis points (to 5.1% and 3.9%, respectively), while leaving inflation forecasts more or less unchanged (at 2.6% and 2.3%). The real short-term rate, as defined above, would thus reach 2.5% by the end of 2024. This represents a very restrictive signal for a long time to come.
This sketches out a change in regime for real rates, which is favourable for bond holders, but unfavourable for the riskiest asset classes, including equities, which are becoming less attractive.
Why be so tough when inflation is falling? In the press conference, Jerome Powell described a more dynamic economic environment than expected. If employment is performing better than expected, it is logical that a tougher monetary policy is required to choke off inflation, which flourishing employment tends to create.
This statement would be perfectly acceptable, if only expectations were relatively certain. But here’s the rub. As Jerome Powell repeated time and again – 11 times during the press conference – the economic expectations produced are extremely fragile. In particular, he considers the “neutral rate”, which neither stimulates nor slows the economy, impossible to predict today, even though he believes it is likely higher than previously, and probably above the long run rate expected by the Fed of 2.5%. This confession of uncertainty – certainly admirable for its honesty – could have caused the Fed to be cautious in managing the expectations provided to the market. Yet the reverse is true – it toughened its rate projections, however fragile they may be. Quite a daring move.