Fed keeps rates steady, but expects policy to be tighter for longer

As expected the US Federal Reserve (Fed) chose not to raise interest rates at its September meeting and left the Federal funds policy rate at 5.25% to 5.50%.

The focus was on the Federal Open Market Committee’s (FOMC) projections for the economy and interest rates, particularly the widely followed “dot plot” of individual members Fed fund projections.

As Chair Powell made clear during his press conference, the economy has proven to be stronger than expected as a result of the ongoing strength of the consumer.

The FOMC’s economic projections now show the median expectation for GDP growth this year at 2.1% (previously 1.1%) and next year at 1.5% (previously 1.0%). As a consequence the unemployment rate is projected to be lower at the end of next year at 4.1% compared to a previous expectation of 4.5%.

Nonetheless, the inflation rate (as measured by the core PCE deflator) is still expected to fall to 2.6% over this period, no different to the June projection. Inflation is then expected to fall back to its 2% target in 2025.

In this respect the Fed believes the trade off between growth and inflation has improved and a misery index would show households to be less glum on this combination of unemployment and inflation than before.

Less positive, from a market perspective, is that the expected level of interest rates needed to achieve this outcome is now higher. The median expected Fed funds rate for the end of 2024 and 2025 has risen by 50 basis points to 5.1% and 3.9% respectively. And a small majority of the committee expects another rate hike before the end of this year.

Given the unchanged inflation projections this implies higher real interest rates. It also means there would only be scope for modest rate cuts in 2024.

In the words of the Bank of England’s chief economist, the rate profile is now more Table Mountain than Matterhorn.