Fed Focused on Higher for Longer, But Rate Cut Talk Likely Coming

Ivanna Hampton: The Federal Reserve makes it two in a row. Fed officials extended the interest rate pause for a second straight meeting. Inflation has moderated, while the job market and economy remains strong. The Fed has acknowledged that tighter financial conditions and credit conditions will weigh on economic activity. Let’s turn to Morningstar Research Services senior U.S. economist, Preston Caldwell, who’s here in studio today. Thanks for being here, Preston.

Preston Caldwell: It’s great to be here, Ivanna.

Hampton: So let’s talk about what are a couple of key takeaways from Fed Chair Jerome Powell’s press conference today?

Caldwell: Yeah, well the Fed didn’t hike today, so they paused again, which—just looking at what markets have expected over the last couple of weeks, was not a surprise. But if we look back a month ago, many people then, as well as the Fed projections, if you looked at them, were anticipating another rate hike. So what’s changed over the last month or so? Well, inflation has continued to trend in a more mild direction. That’s the big thing. And I would say the other factor too is the run-up in bond yields that we’ve seen. And so, all that has induced the Fed to move in a more patient direction.

Hampton: And you mentioned those bond yields. So long-term Treasury yields have climbed to highs we haven’t seen in a while. Talk about how the tighter financial conditions are factoring into the Fed’s inflation fight.

Caldwell: Right. So in short, we don’t know yet. It’s just happened, for example, mortgage rates have gone way up, and so, prospective homebuyers are just now kind of factoring that into their calculations and reacting to what’s happened. And so it’ll take a while for this run-up in bond yields to filter into the economy. Like so many other aspects, actually, I think of the Fed’s rate hikes that have occurred over the last year and a half, the impact has yet to be fully felt. So we will continue to see that. And we don’t know necessarily whether the increase in bond yields will persist, because there could be some supply and demand locations which have been pushing up yields and may reverse a bit. So like Powell said today in his remarks, we’ll have to wait and see whether the increase in yields persists.

Hampton: And Powell has said that officials haven’t been discussing rate cuts next year. What needs to happen for the Fed’s outlook to line up with Morningstar’s forecast?

Caldwell: Yeah, so although Powell did say that, I do think his recent remarks, including a speech a week or so ago, have moved in a direction that is more balanced in recognizing the risks of too-tight monetary policy versus too-loose. Previously it was really just focused on the risk of being too loose, which would cause inflation to remain too high. But now they’re starting to entertain the possibility that the path of policy could be too tight, and that could unnecessarily slow down economic activity more than needs to be done to win the war against inflation. So I think that’s a preliminary to them eventually discussing rate cuts, which I think the discussion will start to be brought up in early 2024, and we’ll start to see some rate cuts actually before the first half of 2024 concludes. And then really deploying aggressively in the second half of 2024 going into 2025.

So we expect the Fed-funds’ rate to ultimately come from its current range of 5.25% to 5.5%, to ultimately below 2%, just under 2% by early 2026. So in our view, that will be necessary to ensure a sustained, healthy rate of economic growth.

Hampton: Well, all right, Preston, thank you for being here in person today. I can’t get enough of it.

Caldwell: Yeah, thanks Ivanna. I enjoyed it.