The stock market may react poorly to this week's FOMC Meeting, despite the well-advertised Fed pause in rate hikes. Fed Chair Powell's post-meeting news conference is not likely to contain new insights into future monetary policy. He will probably repeat the Fed's intent to bring inflation down and leave open a possible resumption of hikes if warranted by the data. However, the macroeconomic evidence so far does not fully support a decision to pause, and the market may fear that worse is yet to come. Indeed, the latest bond sell-off suggests the Fed may be behind the curve, with the decision to pause a mistake. The risk is for bonds to sell off further, hurting stocks. It may depend on the reaction of commodity prices to a pause.
The market will likely focus on the number of rate hikes shown in the Fed's Central Tendency forecasts for the remainder of 2023. The September forecast allowed for one more hike, followed by rate cuts in 2024. Keeping this additional hike on the table would raise two questions. First, what pace of economic growth and inflation will keep the Fed on hold? Second, what is the likelihood that we'll see growth and inflation match the Fed's desired paces?
The Central Tendency forecasts may offer guidance to answer the first question. The Fed may continue to refrain from hiking if its growth and inflation forecasts look like they are being met. So far, economic growth looks to be too strong but inflation in line with the Fed's outlook -- although the high August CPI raises a question regarding the latter. If economic growth or inflation does not slow, longer-term Treasury yields may climb further, substituting for Fed inaction -- a negative for stocks.
US Real GDP Growth so far exceeds the 0.7-1.2% June Central Tendency Forecast for 2023. It grew an annualized 2.0% in H123, and the Atlanta Fed model's latest estimate is 4.9% for Q323. (These figures may change in the benchmark revisions to GDP, due September 28.) This week's update of the Central Tendencies should show an upward revision to its 2023 Real GDP forecasts. However, the markets may focus more on the 2024 Forecast as a guide to what will be an acceptable pace of growth going forward. The June Forecast was for 0.9-1.5% Real GDP Growth in 2024. This forecast may be at risk, since the recent upsurge in commodity prices may be warning that US and global growth are picking up. If the 2024 Real GDP forecast is raised, the Fed's expectation of the funds rate next year might be raised, as well.
To be sure, the June Forecast of 4.0-4.3% for the Unemployment Rate in Q423 looks achievable after the 3.8% printed for August. And, it would be so much the better if it is attained by a speedup in the labor force rather than a decline in jobs, as was the case last month. Doing so would mean the economy can accommodate faster growth without exacerbating inflation. However, a renewed downturn in the Unemployment Rate will likely be problematic for the Fed. And, the latest Unemployment Claims data don't indicate a weakening in the demand for labor.
June's 2023 Central Tendency Forecasts for the PCE Deflator, Total and Core, were being met through July. In July, the y/y was 3.3% for Total and 4.2% for Core, versus forecasts of 3.0-3.5% for Total and 3.7-4.2% for Core for the year. The risk, however, is that Total and possibly Core exceed these ranges in August, given the high CPI.
What may not be fully appreciated by the market is that the June inflation forecast for 2024 is higher than the Fed's 2.0% target. Total was seen at 2.3-2.8% and Core at 2.5-3.1%. These forecasts can be viewed as "intermediate" targets, so that a somewhat higher than 2.0% inflation pace may not trigger a hike through next year. It is somewhat comforting that the latest 3-month annualized increase in the Core CPI is 2.4%. Also, the decline in the University of Michigan's 5-Year Inflation Expectations to a below-trend 2.7% in Mid-September is good news.
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