Yohay Elam, editor of financial website FXStreet, wrote on Tuesday (September 19) that "editing while walking" – a less generous description of the data-dependent policies announced by the Federal Reserve in recent months. Fed Chairman Jerome Powell and his colleagues have gained more trust that the Fed is slowing tightening but has yet to declare victory on inflation, and for good reason. That is why hawkish arguments in favor of the dollar may appear this time.
Here are the forecasts for the Fed's interest rate decision scheduled for Wednesday (September 20) at 2 p.m. ET (2 a.m. Beijing time on Thursday):
The Fed is worried about persistent, resilient consumers
Over the past year and a half, the world's strongest central banks have been focused on fighting inflation. Its efforts have been remarkably successful. Inflation, as measured by the headline consumer price index (CPI), has fallen from a peak of 9.1% in June 2022 to a trough of 3% in June 2023. However, the year-on-year increase in August rose again to 3.7%.
(U.S. CPI inflation, source: FXStreet)
The Fed has a greater impact on costs associated with other goods, services, and housing, and less on energy and food prices in global markets. Core CPI (excluding volatility items) fell to a new cycle low of 4.3% in August from a peak of 6.6% in September 2022.
However, the Fed's inflation target is set at around 2%. The recent 0.3% month-on-month increase in the core CPI has surpassed the gains in previous months, causing unease. This suggests that price pressures have not been crushed, at least not yet.
(US core CPI inflation, source: FXStreet)
Uncertainty also dominates other data points. In addition to inflation, the Fed is also on a mission to pursue full employment. The latest non-farm payrolls report showed that employment growth had slowed, but wages were still up 4.3% year-on-year.
Consumers, who make up about 70 percent of the U.S. economy, haven't stopped their shopping spree. The past two retail sales reports showed a healthy pace of growth – 0.6% in August and 0.5% in July.
According to June's Case Shiller House Price Index (HPI), home prices fell 1.2% year-on-year, but this figure has exceeded expectations for the fifth time in a row.
The Fed raised interest rates to a range of 5.25%-5.50%, but has been gradually slowing the pace of rate hikes, with June pausing it for the first time in more than a year. It then raised borrowing costs in July, in what appeared to be an informal shift to raise interest rates at every other meeting for the rest of the year.
The interest rate decision and hints at the next meeting in November are among three things to watch.
Three scenarios that affect market movements
1) No rate hike, but may hint at a rate hike in November
The Fed is highly likely to keep interest rates unchanged at 5.25%-5.50%, which is a signal to the market, and it usually does. Powell and his colleagues avoided surprising investors. The market has fully priced in a no-rate hike.
However, the next step is uncertain, so dot plots are crucial.
The September meeting included new forecasts, officially known as "economic forecasts summaries" or, in jargon, "dot plots." Each member of the Federal Open Market Committee (FOMC) makes forecasts for economic growth, employment, inflation, and interest rates.
Markets digest data faster than words, and rate expectations at the end of 2023 are critical. In the Fed's last forecast in June, the median reached 5.6%, which is equivalent to two rate hikes above the level at that time. Keeping this figure at 5.6% after already raising rates once in July would indicate that the central bank is not over – or at least unwilling to admit it now.
The bond market expects only a 30% chance of a rate hike in November:
(Bond market interest rate pricing, source: CME)
If the forecast for 2023 remains unchanged, there is room for yields to rise, which will push the dollar higher and put pressure on stocks and gold.
Elam expects Powell to keep the door open for another rate hike, especially after the recent upbeat economic data.
2) A smaller rate cut in 2024 could increase the attractiveness of the dollar
The Fed and investors are already eyeing next year, and they expect lower inflation and a slowing economy to trigger rate cuts.
The June dot plot shows that the median cost of borrowing is 4.6%, a full percentage point lower than the central bank's peak forecast for 2023, or 25 basis points of four criteria.
(June SOMP, Source: Federal Reserve)
At this point, investors and the Fed are more aligned with each other. The bond market expects the Fed to cut interest rates for the first time in July 2024. That makes it possible to cut rates four times in a row in the second half of next year.
In the Fed's new forecast for 2024, will the median interest rate remain at 4.6%? Elam expects the median interest rate to rise slightly, possibly to 4.8 percent, which will scare investors. As the March dot plot shows, if the median is unlikely to fall to 4.3%, the market will rejoice.
Elam wants to emphasize one point that Powell will emphasize – these predictions are not promises, and the further away they are, the less important they are. However, despite the uncertainty, the market still needs to act with certainty.
3) Fed Chairman Jerome Powell's tone may be hawkish
The Fed will announce its decision at 2 p.m. ET on Wednesday, along with an accompanying statement, dot plots that will obscure any changes to the text. Last time these were secondary. Powell will hold a press conference in half an hour.
Looking back at the beginning of this forecast, Powell may insist on relying on upcoming economic data to open the door to raising or cutting rates if necessary.
However, his words are likely to have an impact. If he emphasizes fighting inflation, it will have a negative impact on market sentiment, causing stocks and gold to fall while pushing the dollar higher. If Powell expresses concerns about the economy, mentioning weakness in China, past downward revisions to job growth or weak S&P global PMI data, the dollar will be the only loser. Elam thinks that's unlikely. Most of the recent data has performed well, including resurgence of inflation in the services sector and housing.
The Institute for Supply Management's (ISM) Services Purchasing Managers' Index (PMI), the most respected forward-looking indicator, is also showing signs of bottoming. The index was 54.5 in August, marking an acceleration in economic growth.
(ISM Services PMI, source: FXStreet)
Sum up
The Fed is prepared to keep its interest rates unchanged, but is also expected to signal a final rate hike this year and slow the pace of rate cuts next year. This willingness to curb inflation at a higher cost could hit markets and boost the dollar.
This article is sourced from FX168 Global Investments