FOMC policy decision: The time for an end to rate hikes has arrived

REAL ECONOMY BLOG | July 26, 2023

Authored by RSM US LLP

The Federal Open Market Committee increased its policy rate to a range between 5.25% and 5.5% at its meeting on Wednesday. While the September, November and December meetings remain live options for more rate increases, we think that Wednesday’s hike is the final step in a two-year effort to restore price stability.

With the policy rate standing above two closely watched measures of inflation, the core personal consumption expenditures index at 3.9% and services excluding housing metric at 4.6%, it is now time for the Federal Reserve to give the economy time to absorb the impact of past rate hikes.

We are confident that the evolution of the data will support that move as the consumer price index eases below 3% and the underlying pace of core inflation settles into a range between 3% and 3.5%.

The risks to that outlook are linked to food, oil and energy costs, which to a certain extent will be driven by exogenous factors out of the Fed’s control.

But with hiring, demand for services and transportation costs continuing to cool, we think a 5.5% terminal rate is restrictive enough to push inflation back toward a more tolerable level of 2.5% to 3% over the next two years.

The statement and press conference

The policy statement released on Wednesday remained mostly unchanged. The only notable exception was the fact that the FOMC lifted its policy rate, and that the FOMC did not note any improvement in domestic inflation. This supports our contention that further rate hikes are possible this year given the evolution of economic and pricing data.

The forward guidance component of the policy statement reiterated that the FOMC will remain flexible:

“In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

In the press conference after the meeting, Federal Reserve Chairman Jerome Powell made sure to convey this idea that the Fed may need to lift the policy rates higher at upcoming meetings should inflation resume an upward march.

One should anticipate that both Powell and other Fed officials will continue to note this in order to protect a bridge to higher rates and the central bank’s credibility should food and fuel prices increase.

In contrast with the statement, Powell noted improvements in both the economy and inflation, though he expressed that progress in an appropriately cautious manner given the risks that remain around headline inflation increasing and elevated core inflation.

The takeaway

With the Fed’s latest rate increase of 25 basis points now in the books, we think that improvement in the underlying pace of inflation, cooler job creation and modest growth are creating the conditions where the Fed can effectively end its rate hike campaign.

The Fed is in position to be quite patient in pushing the inflation rate back toward its target of 2% without causing the economy to tip into recession.