As expected, the Federal Open Market Committee (FOMC) decided to keep its key interest rate, the federal funds rate, unchanged at 5.25%–5.50%. Despite the recent resurgence in inflation, the medium-term outlook points to a gradually cooling economy and further decline in core inflation.

That said, continued hawkish rhetoric is likely. Inflation still runs double the 2.0% target level, and the labor market remains tight. Third quarter growth data have been very strong, though we’re unlikely to see a repeat of that in the fourth quarter. While manufacturing and service sector indexes have stabilized, the latest guidance from company reports suggests an increasingly difficult environment for both corporations and consumers. U.S. consumer spending has outpaced income consistently in 2023, which will likely lead to lower spending going forward as excess household savings get depleted.

As long as core inflation (which excludes food and energy prices) trades higher than headline inflation (inclusive of food and energy), the Federal Reserve (Fed) will remain careful. Core goods’ impact on U.S. inflation has become deflationary in 2023 while services (excluding rents) and more volatile items like food and energy have seen a slight uptick lately. Nevertheless, inflation’s breadth (how many goods and services are increasing at the same time) has come down further—an indication for lower core inflation readings going forward. The short-term interest rate market isn’t expecting more rate hikes, and the possibility of rate cuts has been pushed out to the third quarter of 2024 at the earliest.

Our base case is for the Fed to hold until the inflation and growth data weaken enough to justify less restrictive monetary policy. In our inflation framework, we measure inflation’s level (how high it is), breadth, and persistence (how sticky it is). While level and breadth have continued to drop, persistence has just rolled over. Financial conditions have tightened further since the Fed’s last hike: Mortgage rates have risen close to 8%, and the real yield on 10-year U.S. Treasury bonds has risen to 2.5%, last seen in 2006. This makes the addition of more Fed tightening on top of recent market developments less likely.

We continue to like exposure to bonds, which benefit from falling growth and falling inflation. While equities might struggle in the short term with lower earnings guidance, any relief from perceived looser monetary policy would likely support equity prices in the medium term.


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