ETHENEA Commentary: Fed, one last round?

Illia Galka provides an assessment of the upcoming interest rate decision by the US Federal Reserve (Fed) on 3 May 2023: The markets expect a final rate hike of 25 basis points.

After the bankruptcy of California's Silicon Valley Bank (SVB), the Fed's Federal Open Market Committee (FOMC) may have found an unexpected helper in the fight against inflation. Although it has not (yet) led to a major banking crisis, it has tightened conditions in US credit markets. Current indicators suggest that US banks are becoming more restrictive in their lending, with the result that fewer companies want to expand for lack of cheap sources of financing, which in turn contributes to easing inflationary pressures. This should undoubtedly have made Fed members more confident, so that not so many interest rate steps will be needed to fight inflation. Maybe even just one.

The latest figures on economic development paint a mixed picture. In March, the American economy created 236 000 new jobs, just above expectations. The unemployment rate remained steady at 3.5%, while the labour force participation rate continued to rise to 62.6%. Despite the strong labour market, average US wages rose by only 4.2% year-on-year and a barely measurable 0.1% month-on-month. The consumer price index CPI also rose by a very small 0.1% month-on-month and 5% year-on-year in March, a significant decline from February. In contrast, the core inflation rate, which excludes volatile energy and food prices, rose more than the CPI at 5.6% year-on-year, but was still in line with expectations. Going forward, the inflation rate is expected to decline further, but at a level well above the Fed's target. One of the most important signals the economy is sending to central bankers is relatively strong purchases on credit, which suggests that lending has been decent after all so far.

In addition, a series of statements by various Fed representatives in recent weeks have dispelled almost all feelings of uncertainty. The markets now expect a further rate hike of 25 basis points, which would bring the key interest rate into a range of 5.0% to 5.25%. The market-implied probability of such a rate decision, which is also in line with the Open Market Committee's current forecast, is just under 80%. From a market perspective, further interest rate steps in the summer are significantly less likely. Both indicate that the May rate hike could mark the end of the Fed's current rate hike cycle. This seems to be a rare moment of agreement between the Fed and the market. Before, the market did not believe in the Fed's determination to pursue a restrictive monetary policy, just as now it does not believe in the Fed's statements, repeated as if on a continuous loop, not to cut interest rates until the end of 2023. The Fed's rate path implied by the market foresees the first rate cut as early as July, which is far too optimistic in our view. Inflation is still too high and the Fed has said it is willing not to cut rates even in a milder recession. The US central bank has had many rounds of rate hikes and the US economy is showing the first cautious signs of a slowdown. But Fed members seem to be in the mood for one last round after all.