When will the Fed hit the brakes on interest rate hikes?

The monetary policy decisions made by the Federal Reserve (Fed) play a pivotal role in shaping the global financial markets. Among these decisions, changes in interest rates stand out due to their profound impact on borrowing costs, market volatility, currency values, and market sentiment. As markets and economists seek to predict the Fed's actions, understanding the factors that influence the timing of interest rate hikes becomes essential. This article delves into key indicators and considerations that can assist in estimating when the Fed might conclude its rate-hiking cycle.

Economic data and indicators

Inflation dynamics

One of the primary factors guiding the Fed's policy decisions is inflation. An upward trend in consumer prices often prompts the Central Bank to consider rate hikes to prevent overheating, while a downward trend typically calls for a pause in rate hikes or rate cuts. Monitoring metrics like the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) index provide insights into inflation trends.

US Consumer Price Index (CPI) YoY 

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The graph above illustrates the year-on-year change for the US CPI. There is a modest uptick from 3.0% in June to 3.2% in July this year. Although these figures are still above the Federal Reserve's 2% target for the CPI, there has been a consistent downward trend of inflation since its peak at 9.1% in July last year. 

US PCE Price Index YoY

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Meanwhile, the US Personal Consumption Expenditure (PCE) price index, which serves as another inflation gauge and is also the Fed's preferred way of measuring inflation, has decreased from 3.8% in June to 3.0% in July of this year. The PCE price index has exhibited a downward trend since July 2022, similar to the US CPI data.

These two indicators collectively prove that US inflation is on a downward trend. Global financial markets have responded with higher stock market prices and bond prices in the first half of this year. Wall Street has taken comfort in the notion that the recent series of Fed interest rate hikes has effectively cooled inflation, with some analysts prospecting that the latest hike in July 2022 will be the final one.

Labour market conditions

A robust job market can lead to increased wage growth and consumer spending, potentially driving inflation rates. Key indicators include unemployment, labour force participation, and job creation numbers. A strong labour market could signal a need for further rate hikes to maintain economic balance.

Recent data from the US government has highlighted robust hiring in July. The unemployment rate has been ranging between 3.4% and 3.7% since March 2022. This trend represents one of the lowest historical unemployment rates in the US over the past several decades.

US Unemployment Rate (In The Last 2 Years)

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US Unemployment Rate (In The Last 50 Years)

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Typically, during periods of successive aggressive rate hikes, unemployment figures tend to increase as the economy slows down. However, the US labour market has shown remarkable resilience and lower unemployment figures following a series of rate hikes. As mentioned, this suggests a potential upside for more inflation. Therefore, it is possible that the Fed would not be stepping on the brakes on rate hikes anytime soon.

Growth and GDP

The Federal Reserve's decisions are influenced by the overall economic growth rate, which is gauged by the Gross Domestic Product (GDP). A favourable GDP figure reflects a blend of encouraging consumer spending, business investments, government expenditures, and net exports. Rapid growth could lead to inflation concerns, prompting further rate hikes to moderate economic expansion.

US Gross Domestic Product (GDP) QoQ 

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In the second quarter of 2023, the annualised growth of the US GDP rose to 2.4%, compared to 2% in the first quarter. Consumer spending is still growing at an annual rate of 1.6%, but not as quickly as earlier this year. 

This means that despite higher interest rates, stronger business investments power the US economy while consumers remain resilient in their spending. This gives a potential upside to higher inflation and another possibility that the Fed would not be pausing on rate hikes anytime soon. 

Consumer confidence

Increased consumer confidence can result in higher consumer spending, potentially fueling inflation rates. Crucial markers to consider encompass US Michigan Consumer Sentiment and US retail sales figures. A strong upside in consumer confidence might indicate the need for more Fed rate hikes to balance the economy.

US Michigan Consumer Sentiment 

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US Retail Sales YOY

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Both the consumer sentiment and retail sales data depicted above have displayed a recovery trend, especially in the past two months of June and July 2023. This could bring higher inflation in the near future, which may indicate that the Fed is not done with rate hikes.

Global economic environment

The world economy today is highly interconnected, making it necessary for the Federal Reserve to consider international economic conditions. Higher interest rates in the US can reduce financial flows to emerging markets. This can further extend to trade tensions, geopolitical events, currency fluctuations, and overall lower global economic growth.

According to the International Monetary Fund (IMF), global growth is expected to decline from around 3.5 percent in 2022 to about 3.0 percent in both 2023 and 2024. As interest rates rise to combat inflation, this will continue to impact global economic activity.

Financial market signals

Financial institutions and traders usually react to the release of economic data and the Federal Reserve's decisions using both short-term and long-term strategies. Although their market expectations and responses don't directly impact the Fed's rate decisions, they can provide indications of when the Fed might consider pausing its rate hikes or implementing rate cuts. Monitoring the bond market, yield curves, and market-based inflation expectations can yield valuable insights into potential adjustments for future monetary policies. 

For most of this year, the financial markets have been rather optimistic about the conclusion of rate hikes. For example, Wall Street's Goldman Sachs has already started pencilling in the timeline of rate cuts, beginning from June 2024. Concurrently, Bloomberg has indicated that traders anticipate the conclusion of Fed rate hikes and project cuts to commence in 2024, with futures contracts factoring in the first rate cut as early as March 2024.

Forward guidance and communication

The Fed's communication is a crucial tool in shaping market expectations and guiding economic decisions. Statements from Federal Reserve officials, including the Chair's press conferences, speeches, and minutes from Federal Open Market Committee (FOMC) meetings, provide insights into the central bank's thinking and potential policy actions.

The minutes of the most recent FOMC meeting on 25-26 July 2023 indicated that officials remain concerned about inflation and stated that further rate hikes might be necessary in the future unless conditions change.

Watching out for interest rate hikes

Predicting the exact timing of when the Federal Reserve will conclude its rate-hiking cycle is not straightforward due to the myriad of factors at play. Economic data, inflation trends, labour market conditions, global economic dynamics, financial market signals, and the Fed's meeting minutes all contribute to shaping the central bank's decisions. 

However, most of the information gathered as of August 2023 does not seem to advocate a pause in Fed rate hikes yet. There will likely be another rate hike, but circumstances can change. All market participants and economists must stay attuned to these indicators and closely follow the central bank's guidance to make informed assessments about the future path of Fed interest rates.

Source: 

Goldman Pencils In First Fed Rate Cut for Second Quarter of 2024
US Core CPI Posts Smallest Back-to-Back Increases in Two Years