The Fed paused! Following ten consecutive rate hikes, the FOMC refrained from raising the federal funds rate at the June meeting. The summary of economic projections of the committee members offers some insight into their thinking. Despite leaving the overnight rate unchanged, the committee raised its Fed Fund forecast for the end of this year to 5.4% – 5.6%, an indication that they believe additional hikes will be warranted. What likely drove that decision was the lowered forecast for the unemployment rate from 4.5% to 4.1% and the forecast for real GDP revised for this year from 0.4% up to 1.0%.

Following the Federal Reserve-induced banking crisis that gripped the capital markets last month, much debate has focused on the next course of action. Clearly, the Fed’s sharp and relentless rise in interest rates, and negligence of its regulatory responsibility contributed to the demise of Silicon Valley Bank and Signature Bank. From that, an argument can be made that they should pause from any additional rate hikes to evaluate their action to date. If for no reason other than to let any banks that extended duration too soon generate some net interest income. However, an equally persuasive argument is that the inflation mentality is starting to become entrenched.

January was a peculiar month in that the New Year kicked off with a general feeling of malaise in terms of market sentiment stemming from what proved to be a disappointing holiday selling season. The stock market commenced the year trading at the December low as economic data continued to disappoint. The Fed, reacting to the string of weak Q4 economic reports and continued stubborn inflation readings, communicated that they would reduce the magnitude of rate hikes again from 50- to 25-basis points. In holding to their word, they did so at their February 1st meeting. Moreover, the committee members loosely suggested that the peak of the rate would reach 5% and not the 5.25% to 5.50% they communicated just 3 months earlier. That change in messaging succeeded in boosting investor concerns as witnessed in both stock prices and bond yields. The 30-year kicked off 2023 yielding 3.96%, only to close the month at 3.63%, as investors fretted that the economy was on the verge of recession and the Fed would be forced to cut rates later this year. Paradoxically, equity indices rallied for the same reason. The S&P 500 gained more than 6% for the month. While still more than 15% below the all-time high touched in December 2021, the index has rallied nearly 20% off of the 2022 low touched last October.

Judging by the November Consumer Price Index, the Fed’s harsh medicine of higher interest rates is starting to work. While year-over-year CPI still rose 7.1% last month, that’s down from 7.7% in October, and the 0.1% month-over-month increase is exactly what the Fed has been expecting. While the November Producer Price index came in higher than expected, that measure of inflation takes a back seat to CPI in that some of those price pressures can be absorbed by margin compression at the corporate level. The CPI, on the other hand, directly impacts consumers and risks the spiral effect in which consumers expect prices to continue to rise into the foreseeable future.

As of late, there has been little for the Fed to celebrate. The all-important employment report has been relegated to second tier status as the Producer and Consumer inflation measures take center stage as the most important measure of the Fed’s success. With the release of the September report, the Fed’s efforts this year represent a distinct failure. Both measures came in above expectations and didn’t really offer any indication that the rate hikes to date have been successful. The markets reacted mostly as expected. The 30-year bond, after a brief short covering rally on the day of the CPI release is trading just above 4.00%. Similarly, the 2-year note is trading just below 4.50%. Fed Fund futures reset materially higher, with the May 2023 contract indicating a peak Fed Funds rate of 4.93%.