The Federal Open Market Committee decided to leave the federal funds target rate unchanged, at 5.00% to 5.25%. Inflation fighting remains the top priority, which realistically will likely require some form of economic weakening.

A hawkish hold provides the most flexible approach for the Federal Reserve (Fed) going forward. If inflation stays stubbornly high, the Fed has the flexibility to hike again—and it also would be easier to change rhetoric to a more dovish outlook should growth and inflation data roll over more meaningfully. Economic data have been robust the past month, although we’ve seen some signs of weakening lately. The latest data from the Institute for Supply Management showed declines for both manufacturing and services. Also, despite the strong nonfarm payroll numbers, the need for temporary workers is in a downward trend and weekly jobless claims have been more volatile. Consumer demand remains robust, but negative real wages have put renewed pressure on using savings to finance consumption, as indicated by a drop in consumers’ savings rate.

This hawkish rhetoric combined with decent growth and sticky inflation data have led the market to do part of the tightening job for the Fed. The U.S. dollar strengthened lately and real yields rose, especially on the longer end of the yield curve where 10-year yields rose more than 50 basis points (bps; 100 bps equal 1.00%). While just two months ago the short-term interest rate market was pricing cumulative rate cuts of 100 bps during the second half of 2023, that expectation has been pared back to only 25 bps. This is due partly to private sector tightening and stricter lending standards.

Although inflation currently remains the focus, increased attention will be paid to growth developments. Can the economy slow without experiencing a recession and still hit the Fed’s 2% inflation target? It will depend on which number the Fed focuses on—headline or core inflation? The bias to date clearly has been toward less volatile core inflation. Our indicators suggest that core inflation is likely to remain sticky, and while core inflation will likely drop to 3% or below over the medium term, hitting the 2% target exactly will be much harder. This might require a more significant slowdown in growth.

Our base case is for the Fed to be on hold until the inflation and growth data have weakened enough to justify less restrictive monetary policy. Similar to our May outlook, we expect the weakening needed to take more time—patience will be required. With company earnings already in a recession in real terms and the bond yield curve deeply inverted between 2 years and 10 years, pressure on the private sector is rising.

Comparing the bond and equity markets, it seems the bond market expects a more meaningful slowing of the economy while the equity market seems more optimistic. That said, the equity rally year to date—with the S&P 500 Index up more than 13%—has been mainly led by a few large-cap information technology stocks while an equally weighted version of the S&P 500 Index was up only 3.5% because a lot of cyclical sectors struggled.

From a cross-asset-class perspective, we continue to favor nominal assets like equities and bonds while avoiding inflation-sensitive assets like commodities. As long as growth doesn’t slow more meaningfully and default rates stay well behaved, we also see value in earning the income in higher-yielding bonds, like corporate or high yield bonds.


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